Leading Canadian transfer pricing cases favour domestic rules over OECD guidelines by Shaun T. MacIsaac, Q.C.
TP Week Issue, August 21, 2014 - Until the decision in the GlaxoSmithKline (Glaxo) case, all previous Canadian court decisions had slavishly applied the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. How do the guidelines now fit into the law and a practical strategy of establishing the correct transfer prices?
Provisions of Canadian law, the guidelines, and the administrative circulars and memoranda of the Canada Revenue Agency (CRA) as set forth in Circulars and Transfer Pricing Memorandums are all in a process of continual evolution. They are applied to a wide variety of diverse fact situations and transactions. It is useful to understand the different ways Canada's five recent transfer pricing court decisions have applied the law, the guidelines, and administrative positions of the CRA in various types of pricing disputes to establishing correct arm's-length transfer prices.
The law was section 69(2) of the Income Tax Act, (Act) from 1972 to 1998, and then section 247(2) in its original form from 1998 to 2012. There were revisions to section 247 in 2012 and 2013 that added subsections (12) to (15) which deal with deemed dividend and repatriation provisions, and clarify withholding tax issues and secondary adjustments.
The guidelines were first established in 1979 and dealt with financial transactions. The 1979 Guidelines were amended completely in 1995, but guidance on financial transactions was omitted from the 1995 Guidelines. The guidelines were amended in part in 2010 by revisions to Chapters 1-3 regarding comparability and profit methods, and Chapter 9 concerning restructuring. Chapter 4 was revised in 2013 and deals with safe harbours. Chapter 6 of the guidelines regarding intangibles is in the process of a series of discussion drafts, and new guidelines on Chapter 6 are expected shortly. Even though guidance on intra-group financial transactions is expected to be revisited as a new priority of the OECD, at present there is an absence of specific guidance on how to apply the arm's-length principles to such transactions.
Circular and TPMs
The CRA's first Information Circular on transfer pricing came out in 1987, and was revised as information circular IC87-2R in 1998. Related to the Circular, and forming an update on the CRA's views as these change from time to time, are the 14 documents entitled Transfer Pricing Memorandum (TPM).
The legal cases then considered the state of the law, the guidelines, and the relevance of the Circular as they applied to widely different transactions.
1. General Electric Capital Canada Inc. v. R 2010 DTC 1353 TCC, affirmed 2011 DTC 5011
The Federal Court of Appeal had to decide the arm's-length price of a financial guarantee given to a Canadian subsidiary by its foreign parent. At issue was the significance to attribute to the "implicit support" that the Canadian subsidiary would be expected to enjoy by virtue of having a foreign parent. The Minister's argument was that the foreign parent would have covered the liabilities of its subsidiary whether or not a guarantee was provided, and therefore the guarantee had no value. The tax years under appeal were 1996 to 2000. Section 247 (2) of the Act, in the way it read from 1998 to 2012, set forth the power of the Minister to "adjust the quantum or nature of the amounts (the transfer price) to the amounts that would have been made between persons dealing at arm's-length".
Paragraph 1.6 of the 1995 Guidelines was relied upon in paragraph 57 of the judgment where Justice Noël of the Federal Court of Appeal held that the existence of an implicit guarantee was truly relevant, as the comparison of controlled and uncontrolled transactions should relate to the "conditions which would have been obtained between independent enterprises in comparable transactions in comparable circumstances". As none of the OECD transfer pricing methodologies applied to the facts of this case, the trial judge and the appeal court had to make a decision on the arm's length price based on general evidence of comparability.
It was found that the "discount yield method" was the most reliable way to decide the issue. The decision was not a good example of an application of the guidelines, as there was no specific guideline to apply.
The taxpayer won the appeal based on a finding of fact by the trial judge upheld on appeal based on the discount yield method. With this method a taxpayer in the position of the Canadian subsidiary would have had to pay more on the open market than the price that the parent charged the subsidiary for the guarantee in this case, and thus the price was arm's-length.
2. GlaxoSmithKline v. R 2008 DTC 3957 (TCC), reversed 2010 DTC 5124 (FCA), upheld 2012 SCC 52
The facts involved the determination of an arm's-length price for the supply of an active pharmaceutical ingredient by an affiliated company to a Canadian subsidiary. Related to the supply agreement was a licence agreement with a different related company.
The Minister relied on a Comparable Uncontrolled Price (CUP) related to the cost of the active pharmaceutical ingredient from generic suppliers that sold it in Canada, and put forward this CUP as the first choice methodology in accordance with the hierarchy of transfer pricing methodologies in the 1995 Guidelines. The CUP is also the preferred methodology to be followed under the 2010 Guidelines.
The taxpayer relied on CUPs relating to supplies of the same product to other related subsidiaries by it, and also on a cost plus method. Costs paid for the active pharmaceutical ingredient by other taxpayer related subsidiaries to its parent were presented as comparables.
The tax years under appeal were 1990 to 1993 and the law under consideration was Section 69(2) of the Income Tax Act in force from 1972 to 1997. This section contemplated an adjustment when the amount paid to a party with which a taxpayer did not deal at arm's-length was greater than a "reasonable" amount.
With respect to the applicability of the guidelines, Justice Rothstein of the Supreme Court of Canada ignited a debate on the significance of the guidelines by stating that the OECD guidelines were "not controlling as if they were a Canadian statute" (paragraph 20 of the decision). Just as importantly, the court went on to ground its reasoning for the reversal of the Minister's outright win at trial by insisting that the approach to the case should be made having regard to a number of terms expressed in the 1995 Guidelines.
Transactions are comparable when there are no material differences, or adjustments can eliminate material differences (paragraph 1.15 of the 1995 Guidelines and paragraph 23 of the decision).
All economically relevant characteristics must be comparable for a comparable to be useful, (paragraph 1.15 of the 1995 Guidelines and paragraphs 41 - 42 of the decision). The court then applied this principle to the facts by finding that a relevant CUP had to consider the value in this case to the purchaser of both the supply agreement and the licence agreement, in order to find a transaction truly comparable. The court listed its findings regarding the value of the embedded intangibles obtained by the purchaser of this active pharmaceutical ingredient as a bundle of rights conferred on the purchaser.
While the arm's-length principle requires a transaction to be evaluated on a transaction by transaction basis, this rule only applied where the transactions are not so closely linked that they cannot be evaluated separately (paragraph 1.42 of the 1995 Guidelines and paragraphs 39 and 40 of the decision). Effectively, this meant that the purchase of the active pharmaceutical ingredient could not be separated from the bundle of rights related to the imbedded intangibles that have value.
The decision was then returned to the tax court, but the Justice directed the trial judge to make a new decision, and to give greater consideration to the value of the rights obtained by the purchaser in this case based on the supply agreement and the licence agreement. This should decrease the adjustment, which should be of assistance to the taxpayer.
The court's application of guidelines that were not even in effect at the time of the transaction tells us that a taxpayer cannot depend merely on the guidelines in effect at the time of a transaction, but must anticipate future trends, and if a dispute arises use whatever guidance is logical and available to defend its pricing strategy. It also suggests that older transactions may have to be revisited and looked at from the point of view of newer trends when determining if there is possible risk.
3. Alberta Printed Circuits Ltd v The Queen 2011 TCC 232, 2011 DTC 1177
The facts considered the determination of an arm's-length price for the supply of "set-up" and other IT related services by a foreign subsidiary to a Canadian parent. 78% of the adjustment sought was for set-up services and 22% of the adjustment was sought for IT services.
The taxpayer sought to support the price paid for set-up fees by relying on internal and external CUPs, and a Transactional Net Margin Method (TNMM) to defend the transfer prices of the combination of both the set-up and IT services.
The Minister presented a TNMM only. This was a battle between the applicability of two OECD methodologies.
Many of the provisions of the guidelines and Circular were at issue and were relevant to the facts in issue in the expert reports filed with the court.
The taxation years under appeal were 1998 to 2000. The case went to trial after the appeal court decision in the Glaxo case, but before the Supreme Court of Canada decision.
Section 247(2) of the Act, as it read in the years under appeal was in issue, called into question whether the terms of the two services transactions differed from an arm's-length price.
The 1995 Guidelines were followed. It was found that the 2010 Guidelines were "well beyond the taxation years in issue".
With respect to the guidelines and the Circular, the court relied extensively on the guidelines to support the process of searching for a CUP as the most reliable proof of an arm's-length price, and then rejected methodologies of lower reliability. Justice Pizzitelli of the Tax Court of Canada held that:
The 1995 Guidelines inform subsection 247(2) of the Act, and approve of the transactional and profit methods (paragraph 155 of the decision);
Comparability was of paramount importance (paragraph 61 of the Circular as noted in paragraphs 162 and 170 of the decision);
Sales by a taxpayer to another member of the taxpayer's group supported a finding of an internal comparable (paragraphs 53 and 64 of the Circular and paragraph 187 of the decision);
There is an overwhelming preference for the highest transfer pricing method which included an internal CUP used in an acceptable manner within the rules (paragraph 60 of the Circular and paragraph 200 of the decision). This point has now been updated by paragraph 2.3 and 2.4 of the 2010 Guidelines, which were not considered; and
It is not appropriate to use other methods simply because data concerning uncontrolled transactions is difficult to obtain, and adjustments should be made to the data to use the CUP method (paragraphs 2.7 to 2.9 of the 1995 Guidelines and paragraphs 170 & 171 of the decision).
The taxpayer's CUP was found to apply to the set-up fees which vacated 78% of the proposed adjustment, so that the price paid for the set-up services was found to be arm's-length. This was a significant win for the taxpayer, and is a good example of judicial acceptance of proof of internal and external CUPS, and the importance of leading expert evidence relating to the value of intangibles owned or used by the parties to support the proof of these CUPs. The adjustment was upheld in part as it related to the IT services for which there was no CUP. The court rejected the Minister's TNMM analysis and stated that it could be applied where assumptions regarding the use and ownership of intangibles by the Canadian parent were not proven (paragraph 217 of the decision).
AP Circuits is a good example of the standard of proof needed in court to establish a CUP in accordance with the guidelines, the weakness of a TNMM grounded on mistaken assumptions regarding intangibles, and the importance of grounding a transfer pricing strategy in proof of the facts of the case and the guidance from the guidelines.
4. McKesson Canada Corporation v the Queen 2013 TCC 404
This was a factoring transaction done by a Canadian subsidiary with its foreign parent.
The tax year under appeal was 2003. Section 247(2) of the Act in the form it read from 1997 to 2012 was in issue.
Justice Boyle of the Tax Court of Canada decided that the issues at hand were to be decided by a fact finding and issue evaluation by the trial judge, rather than by the application of an OECD methodology (paragraph 120 of the reasons). He reasoned that the "... Guidelines not only were written by persons who are not legislators, but in fact are (written by) the tax collection authorities of the world", and thus "Their thoughts ought to be treated accordingly" (paragraph 120 of the decision). For the first time, a Canadian court questioned the value and weight of the OECD's guidelines.
The Justice expressed his concern that neither party had led evidence of the nature he would have expected. No evidence of credit risk or credit default insurance was led by either party (at paragraph 153 of the decision). The Justice noted that he was constrained by the limitations of the evidence before him (paragraph 304). There was also the practical limitation of an absence of useful guidance on factoring transactions from the guidelines, the Circular or the TPMs.
The Justice noted that the 2010 Guidelines, paragraph 2.9, confirm that when neither the transaction based methodologies nor the profit based methodologies of the OECD apply, an "other method" was needed to make a decision (paragraph 217 of the judgment).
The Justice then arrived at a calculation of an arm's-length discount rate of between of between .959% and 1.1%, and compared that with the amount charged of 2.206%, and concluded that the price paid was not arm's-length.
The Justice found that the "primary purpose" of the transaction was to save taxes, and not any other business purpose (paragraph 275 of the decision). This comment must be taken to relate to the power to recharacterise a transaction in Canada where it can be considered "not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit" in subsection 247(2)(b), but that subsection was not in issue in the case. The Justice was suggesting he would have found that the only purpose of the transaction was a tax purpose had he been asked this question. This finding may have had led to even worse results for the taxpayer had this issue been raised. The other part of the test in subsection 247(2)(b) is whether a businessman would have entered into the transaction in question, and one wonders why a factoring transaction would be considered abnormal.
The taxpayer was not successful, as they could not defend a factoring transaction where the Justice made findings of fact that the amount that should have been charged for the factoring services was too high based on findings of fact made on what reasonable components of the discount rate should have been.
This case points out the obvious need for more guidance on financial transactions from the OECD, but also underlines the emerging risks for taxpayers from financial transactions, especially ones that appear to be tax structures without an underlying business purpose.
The McKesson case shows that the Minister is succeeding in transfer pricing cases, and challenges to tax structures by the Minister are being supported by favourable court decisions on a principled basis.
5. Marzen Artistic Aluminum v The Queen 2014 TCC 144
A Canadian Parent paid net fees of $2,110,502 in taxation year 2000 and $5,025,190 in taxation year 2001 to its Barbados subsidiary. The Barbados subsidiary then repaid these fees to its Canadian parent from the Barbados subsidiary's exempt surplus.
The taxpayer's position was that the controlled transaction between the Canadian parent and the Barbados subsidiary should be treated as part of an amalgam involving the pricing of the value of other transactions between the Canadian parent and an American subsidiary. This approach was rejected by Justice Sheridan of the Tax Court of Canada (paragraph 181 of the Reasons). The taxpayer also suggested a theory of the case suggesting that a Global Formulary Apportionment Approach should be applied. This was also rejected by the court as being inconsistent with the arm's-length principle (paragraph 191 of the Reasons).
The Minister's position was that the value of the services provided by the director of the subsidiary to the subsidiary related to an internal CUP, which was the sum of $32,000 per annum being paid by the Barbados subsidiary to that individual.
The court upheld the vast majority of the adjustment and relied on the CUP to establish a minimal value for the services.
The court found that evidence of the alleged value of the services provided did not justify a significant fee as the Barbados subsidiary had no personnel, no assets, and no valuable intangibles or intellectual property (paragraph 136 of the Reasons).
The Justice noted that the transfer pricing law in subsection 247(2) of the Act is supplemented by the 1995 guidelines and the Circular. The legal cases of Glaxo, General Electric and AP Circuits were all relied upon to support this view (paragraph 176 of the Reasons). The guidelines were described as having been endorsed by the Canadian Courts to assist in determining what a reasonable person would have paid if the parties were dealing at arm's-length "because the Act is silent on how to carry out the analysis contemplated by subsection 247(2)" (paragraph 177 of the Reasons). This view of the role of the Guidelines differs from the McKesson case, and is consistent with all previous decisions and the wording of the Circular, where it is stated that "Section 247 is intended to reflect the arm's-length principle expressed in the OECD Guidelines" (paragraph 47) .
In expressing its reasons, the court relied on an internal CUP. A proposed TNMM and an approach based on Global Formulary Apportionment were rejected on the basis that the facts to support them were not proven, and that these methods were less reliable (paragraph 191 of the Reasons).
Whereas in AP Circuits, the taxpayer proved an internal CUP and rejected TNMM approaches and then vacated 78% of the adjustment, in the Marzen case, the Minister proved a CUP, and the taxpayer's TNMM was rejected.
Canadian courts have re-affirmed their preference for a CUP. The Minister has obtained favourable results in litigation by following it.
Future cases and trends
It is early in the history of transfer pricing cases, but the trend towards judging older transactions under current thinking is firmly established. The courts have shown a willingness to reject tax structures without underlying business purposes. They are likely to continue to grasp new issues as they emerge.
All five legal cases applied the law, and all relied upon provisions in the guidelines. Glaxo, AP Circuits and Marzen define their reasoning in supporting winning arguments by reference to provisions of the guidelines.
New cases will consider different facts and apply different economic, accounting and valuation issues. The application of the guidelines and the Circular will vary in accordance with the factual issues of an individual case. A thorough grounding on the law, the guidelines to apply, and the approach of the CRA in the Circular and the various TPMs, will still be the key to successful results.
by Shaun MacIsaac, QC
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