Selected Canadian litigation aspects of international pricing disputes: effect of proposed changes
Salvador M. Borraccia
Since the Tax Reform Act of 1986 in the United States introduced the so-called super-royalty provision, transfer pricing has received an increasing amount of attention both from government and business. The United States is Canada’s largest trading partner and the effect of U.S. developments on Canadian corporations dealing with related U.S. corporations will be significant.
Canadians have been largely successful in resolving transfer-pricing disputes prior to litigation, especially those with U.S. corporations. Competent authority has been one of the major reasons. Will this continue? This article explores the Canadian administrative and judicial attitude to the resolution of such disputes and attempts to assess the future effect of recent Canadian and U.S. developments.
I. The Statutory Framework for the Assessment
The basic Canadian charging provisions are subsections 69(2) and (3) of the Income Tax Act.(1) The former governs payments to a non-resident person with whom a Canadian taxpayer was not dealing at arm’s length;(2) the latter, inadequate consideration paid to a Canadian taxpayer in the same circumstances. The common benchmark is the amount that would have been reasonable in the circumstances had they been dealing at arm’s length.(3) The provisions are extremely broad and catch virtually all intercompany property or service transactions.
Revenue Canada has essentially adopted the OECD approach to intercompany pricing and has stated that the comparable uncontrolled price method is to be favored if obvious comparables are available.(4) Revenue Canada recognizes that the application of this method tends to be restricted by the difficulty in establishing that the product involved, market, credit terms, reliability of supply, and other pertinent circumstances may not be comparable. It further believes that variations in the respective circumstances should be minor or capable of quantification on some reasonable basis. In the event that a comparable uncontrolled price cannot be determined, it accepts other methods. The other three methods are cost-plus, resale price and the so-called fourth method — really any other method that may be used in the circumstances. Revenue Canada, however, takes the transactional approach to intercompany pricing and believes that each transaction must stand on its own merits. It recognizes the role of functional analysis in establishing prices resulting in a quantum of income being taxed in Canada consistent with the real profit contribution of the Canadian taxpayers involved. In fact, Revenue Canada’s audit guidelines suggest that formula methods such as group profit allocation (eg., based on percentage of Canadian to worldwide sales or costs) may be suitable in some circumstances but usually only as a last resort.(5)
Revenue Canada has not published any formulae, benchmarks, or safe havens upon which taxpayers may rely. This may be owing to the difficulties in addressing many divergent situations. Unfortunately, this produces a great deal of uncertainty for taxpayers who must struggle with little official guidance.
II. Pricing Disputes in the Canadian Courts
Although few pricing cases have made their way through the Canadian tax courts, some principles have evolved that provide insight into the course the Canadian courts may follow in the future.
A. Onus of Proof
In his reply to the taxpayer’s notice of appeal, the Minister of National Revenue pleads the facts or assumptions of fact upon which his assessment is based and states the reason for the assessment. The Minister’s facts are assumed to be correct and the onus is on the taxpayer to demolish the exact assumptions made by the Minister at the time of the assessment.(6) The taxpayer can show that the Minister’s facts are incorrect or incomplete and that his own evidence is to be preferred. He can also show that the Minister’s position is not correct in law. Inasmuch as a pricing case is normally factual, the taxpayer’s evidence typically shows that the disputed amount would have been reasonable in the circumstances had the parties been dealing at arm’s length. A statement by the Minister that the amount was not reasonable is a conclusion based upon the facts assumed by the Minister. The reasonableness of the amount is for the court to determine.
If the taxpayer’s evidence is sufficient to rebut the Minister’s facts, the onus will shift to the Minister to adduce further evidence in support of the assessment. Most often, the Minister attempts this through cross-examination of the taxpayer’s witnesses and introduction of his own evidence (e.g., testimony by the tax auditor or expert witnesses).
A significant advantage accrues to the taxpayer — the knowledge of his company and the industry in which it operates. The taxpayer, if properly guided, is often in the better position to develop comparables, especially from outside Canada, and other evidence necessary to prove his case and appreciate the reason for variances.
If the Minister arbitrarily determines the relevant amount, his assessment can be upset with the minimal of evidence. For example, in Central Canada Forest Products Limited v. M.N.R.,(7) the taxpayer was a shell Canadian corporation that was used as a convenient legal entity to obtain pulpwood rights from the province of Ontario. It then transferred the equity in them to its American parent company at its cost. The Minister felt that the appellant had achieved a bargain in acquiring the rights from Ontario based upon comparisons to allegedly similar contracts entered into by other companies. The comparables were to unnamed companies, but the evidence showed that the timber limits used for the comparisons were a great distance away from those relevant to the appeal.
The Tax Appeal Board noted that the Minister had not given any expert evidence concerning value, thereby leaving the Board to deal with the matter on the basis of unsatisfactory and flimsy evidence. An important fact was taken to be that the timber rights had been obtained by the appellant as a result of a public sale that had called for sealed tenders in which the appellant’s was the highest. The Minister failed to adduce any evidence to establish the similarity of the comparables used by him and, therefore, the evidence adduced by the appellant was sufficient to discharge the onus on it. Although the case is not important for its facts or analysis, it shows that the burden placed on the taxpayer can be relatively light where the Minister does not have adequate evidence. This may be especially important when dealing with unique goods and services where no true comparable exists and it is necessary to extrapolate the reasonable amount.(8)
In Ancaster Development Company Limited v. M.N.R.,(9) the court applied a resale price method. The basic facts were that the taxpayer company sold several building lots to one of its non-arm’s length shareholders in 1952. The Minister’s assessor determined that since similar lots were sold in 1953 to outsiders at a price of $1,500, that same $1,500 price should be applied to the 1952 transaction. The Tax Appeal Board(10) had agreed with the Minister that subsection 15(2) would apply since the appellant had failed to discharge the onus on him. The court took a more realistic approach and determined that there were two relevant factors that had not been taken into account by the Tax Appeal Board. The first was that there had been an increase in prices during the period 1952 to 1953 so that prices in 1953 were generally higher. Interestingly, the court did not reject the sales comparables. The second factor was that the Tax Appeal Board did not allow a discount for purchase of several lots. The court considered that the relevant trade level was at wholesale and tried to determine what the wholesale price would be in the circumstances. In particular, it determined that the price should be such as would be to allow a purchaser to sell at retail with a 20 percent profit plus $50 per lot carrying charge.
The Canadian courts have tended to shy away from a mechanical comparison of prices and have looked at the surrounding facts. In J. Hofert Limited v. M.N.R.(11) the taxpayer had been in the business of harvesting and shipping Christmas trees, most of which were sold under contract to a U.S. company with which the taxpayer was not dealing at arm’s length. The taxpayer also sold some trees in the Canadian market at between $2.75 and $3.19 per bale. The price for the trees sold to the United States was $2.00. The Minister assessed on the basis that the trees sold to the affiliated company were sold below fair market value. This is another case in which the Minister failed to adduce any evidence other than that elicited through cross-examination of the appellant’s witnesses. In fact, the Tax Appeal Board remarked that the Minister lacked knowledge of any fair market value and that the appellant’s evidence in that regard was the only definite evidence on the subject placed before the Board.(12) This tended to negate anything put forward by counsel on behalf of the Minister. The Board took into account a number of factors in determining that the Canadian price could not be used as a comparable to the subject transaction. First, the Board considered the level of distribution. In the U.S. case, the trees were purchased for resale to distributors, wholesalers and retailers. In Canada, the taxpayer sold trees to retailers only. The terms of the sale were also taken into account. All bales of trees purchased by the U.S. company were paid for even if numbers of the bales later proved unsuitable for resale. On the other hand, trees sold to Canadian purchasers were not paid for if found unsatisfactory. The appellant took back every unsold tree from Canadian purchasers. The sales expenses in Canada were also considerably greater than those in the United States since it was not necessary in the United States to have a sales organization as it was in Canada. The Board also took into account that although higher prices were charged in respect of Canadian sales, the ratio of annual net profit on such sales was no higher than that of the sales to the American buyer. This was used by the Board to evidence that there was no preferential price treatment given to the U.S. buyer. Because of the differences in circumstances, the Board would not use the Canadian prices as evidence of the fair market value that should have been paid by the U.S. affiliated company. The Board was also willing to take into account a long recognized trade practice that the bigger the purchase the lower and more attractive should be the price. Thus, the Board was not hamstrung by finding identical comparables.(13)
B. Artificiality and The Market Test
Historically the Canadian courts have used fair market value as a benchmark to determine whether the Act’s anti-avoidance provisions applied. For example, in Spur Oil Ltd. v. The Queen,(14) the court decided that payment by the taxpayer of a transportation charge to a related affiliate in connection with the purchase of oil that it had previously obtained from an American affiliate at a lower price did not result in an undue or artificial reduction of its income. The test applied by the court was whether the taxpayer had paid more than the quoted value.(15)
The taxpayer was less fortunate in Indalex Limited v. The Queen.(16) The taxpayer was a Canadian company that nominally ordered raw material through a Bermuda affiliate that had entered into a legal contract with the supplier in Canada. The supplier sold the goods to the Bermuda affiliate which in turn sold them to the taxpayer at the same price. The supplier’s parent company, however, then credited the Bermuda affiliate for “discounts” attributable to the purchase price. The court determined that the discount was really earned by the taxpayer rather than the Bermuda affiliate since it was the taxpayer that, in substance, was providing part of the purchasing power for the material.
The contrast between Indalex, on the one hand, and Spur and Irving, on the other, appears to be that in Spur and Irving the taxpayer did not pay more than the quoted market price for the product in the latter two cases. In Indalex, the court was able to determine that the Canadian company would have achieved a discount from the supplier had it acted on its own and none of the discount was attributable to the Bermuda affiliate’s activities.
There are substantial similarities between Indalex and the earlier case of Dominion Bridge Company Limited v. The Queen.(17) In Dominion Bridge, Span, a shell corporation was incorporated in the Bahamas by Dominion Bridge, a Canadian company that purchased steel for its operations. Although it purchased 85 percent of its steel requirements in Canada and the United States, it obtained the balance from offshore mills either directly or through commission agents. Span was closely controlled by Dominion Bridge. All aspects of Span’s business were dictated by it, with Dominion Bridge’s even setting the price at which it purchased the material from Span. It chose to pay Span 95 percent of the price of domestic steel for offshore steel that had a lower market value. This resulted in a substantial profit accruing in Span which, under section 28(1)(d) of the pre-1972 Act, could be paid by dividend to Dominion Bridge free of Canadian tax.
As in Indalex, the court found that the offshore company did nothing on its own, but rather acted only for its Canadian counterpart. It treated Span as a puppet to make Span and the taxpayer a single economic entity. The court chose not to deal with the matter on an intercompany pricing basis; rather it presented the issue as one of fact: “Are the operations under scrutiny those of the appellant or of Span?” One of the factors weighing heavily on the court was that by setting the purchase price at 95 percent of the price of domestic steel, Span was permitted to make about an 18 percent profit that would have been made by Dominion Bridge if it had paid the market value of offshore steel in lieu of the market value of domestic steel. This payment of excess price was a key determinative for the court in its decision that the set-up constituted an arrangement or scheme which was merely a device to secure a tax advantage to which device the trappings of normal dealings were given by the appellant and that the paramount objective of doing so was the avoidance of tax. In summary, the court found that the acts performed and the documents executed by Dominion Bridge were intended to give third parties the appearance of rights and obligations different from the actual rights and obligations that were created; therefore, the arrangement constituted a sham within the meaning of Snook v. London and West Riding Investments Ltd.(18)
It is interesting to consider whether the decisions in Spur Oil and Irving Oil would be different had they been subject to the scrutiny in the general anti-avoidance rule in subsection 245(2). A complete discussion is beyond the scope of this paper. That fair market value was paid in both cases should be a significant factor enabling a court to conclude that there was not a misuse or abuse of the Act. Nevertheless, the result remains uncertain.
III. Competent Authority
The basic provisions of the Canada-U.S. Income Tax Convention affecting transfer pricing are contained in Articles IX and XXVI. Article IX deals with related party transactions that differ from those that would be made between unrelated persons. Paragraph 3 of Article IX basically provides that, in the event of an adjustment by one of the contracting states, the other contracting state shall, notwithstanding any time or procedural limitations in the domestic law of the other state, make a corresponding adjustment to the income, loss, or tax of the related person if two conditions are satisfied. First, it must agree with the adjustment. Secondly, within six years from the end of the tax year to which the adjustment relates the competent authority of the state must be notified of the adjustment. Pursuant to paragraph 4 of Article IX, in the event the notification is not given within the period and if the person to whom the adjustment relates has not received, at least six months prior to expiration of the time period, notification of such adjustment from the contracting state that has made or is to make the adjustment, then that state shall not make adjustment to the extent that such adjustment would give rise to double taxation. The Technical Explanation notes that the notification required in paragraph 3 may be made by any other related persons involved or by the competent authority of the state that makes the initial adjustment.(19)
IV. Effect of U.S. Developments
As previously stated, the United States has been active in enacting legislation to counter perceived tax abuse occurring by way of intercompany pricing and to help it gain the upper hand in the litigation of intercompany pricing cases.(20) As a result, it has made or proposed substantial changes in section 482 of the Internal Revenue Code and the attendant regulations. To what extent will these changes have an effect on litigation of intercompany pricing disputes in Canada? In order to answer this question, it is useful to consider some of the major changes that have been made and proposed and to consider their likely effect on a Canadian corporation that is a party to a transaction that is adjusted or proposed to be adjusted by the Internal Revenue Service.
Section 482 of the Internal Revenue Code allows the Secretary of the Treasury (or his delegate) to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among organizations owned or controlled directly or indirectly by the same interests. The IRS may do so if it determines that it is necessary in order to prevent the evasion of taxes or clearly to reflect the income of such organizations, trades or businesses. In 1986, section 482 was amended to include the “super-royalty” provision which provides that “in the case of any transfer (or license) of intangible property … the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” A 1988 “White Paper” on transfer pricing following the statutory change(21) suggested that the application of that standard requires the determination of the income from a transferred intangible and a functional analysis of the economic activities performed and the economic costs and risks borne by the related parties in exploiting the intangible so that the intangible income can be allocated on the basis of the relative economic contributions of the related parties. The White Paper further suggested that this standard requires a periodic redetermination and reallocation in order to reflect substantial changes in intangible income or changes in the economic activities performed and economic costs and risks borne by the related parties.
Senior Revenue Canada officials have expressed the view that if the terms and conditions of an agreement are arm’s length at the time the agreement is entered into, then the agreement should be respected for tax purposes. Therefore, a retrospective adjustment of a type that would not occur in an arm’s-length situation raises a possibility that Canadian authorities would not accept such an adjustment. This could lead to an increase in a number of competent authority cases and the possible failure of the competent authorities to reach agreement to avoid double taxation. The problem could be particularly acute in respect of lump-sum buy-ins where all the rights are transferred in one year.
The proposed regulations would change the arm’s-length standard from its current definition of “an uncontrolled taxpayer dealing at arm’s length with another uncontrolled taxpayer.”(22) This arm’s-length standard would appear to be similar to that adopted by the Canadian courts. Prop. Treas. Reg. [section] 1.482-1(b)(1) would change this standard to “uncontrolled taxpayers, each exercising sound business judgment on the basis of reasonable levels of experience, (or, if greater, the actual level of experience of the controlled taxpayer) within the relevant industry and with full knowledge of the relevant facts, would have agreed to the same contractual terms under the same economic conditions and other circumstances.” This change would seem to require an adjustment to the Canadian arm’s-length standard and decrease the importance of comparables since it would be necessary to add in the imputed knowledge factor.
Would this standard be consistent with the “reasonable amount in the circumstances”? The Canadian test is qualified, of course, by the fact that the parties would have been dealing at arm’s length. Thus, there seems to be a divergence between the Canadian standard and the U.S. proposed standard. If the parties had been dealing at arm’s length, there would be no reason to suspect that the arm’s length person would have had the imputed knowledge required by the proposal. The proposed regulations would also empower the IRS to consider the combined effect of all transactions of a controlled taxpayer with other members of the group as well as with the uncontrolled taxpayer before, during and after the taxable year under review. Thus, the IRS would be authorized to look at all aspects of a particular transaction — for example, a license and a resale from the manufacturing company to the licensor of the product manufactured. Revenue Canada has generally insisted on a transaction-by-transaction approach to intercompany pricing.(23) In the event that there were discrepancies between fair market value and price paid by the contract manufacturer, for example, Revenue Canada might employ section 245 to consolidate the two transactions and determine whether the unreasonable consideration arose from the two transactions. Under the proposed U.S. regulations, the IRS may disregard contractual arrangements or the absence of contractual arrangements between related parties in determining whether the parties have dealt with each other at arm’s length. Under Canadian law, in the absence of a sham, the courts have generally been accepting of contractual arrangements between related parties and have taken those contractual arrangements into account.
The provision that arguably deviates most from the arm’s-length standard is the proposed use of the “comparable profit interval” (CPI). This is determined as the range of hypothetical operating incomes of the taxpayer being examined or the other controlled party to the transaction.(24) Basically, hypothetical operating incomes are determined by computing the amount of operating income the taxpayer or the other controlled party would have earned if certain empirical measures of profitability were the same for the taxpayer as for uncontrolled parties in the same or similar business. The two functions of the CPI are, first, to test the validity of the taxpayer’s transfer prices as they are derived from other methodologies and, second, to be an independent method for determining arm’s-length transfer prices with respect to the sale or transfer of both tangible and intangible property. The appropriate taxpayer must first be selected and the applicable business classification determined. Then the tested party’s constructive operating incomes must be ascertained and the CPI constructed from the constructive operating incomes.
The proposed regulations provide that the data to be used are those of a three-year period comprising the tax year being reviewed, the preceding tax year, and the following tax year. Thus, the test for CPI seems to differ markedly from the reasonable amount in the circumstances test used in the Act. Relying more on hindsight rather than foresight, the proposed regulations seemingly move away from the normal determination of what Canada in particular has been trying to achieve up to this point. In addition, because the CPI uses broad industry averages that may or may not reflect a particular organization, it is arguably doubtful that the CPI applies on a micro rather than macro view. Hence, whereas CPI may be an interesting average of all the companies in a particular industry sector, it may not reflect what would have been reasonable in the circumstances for the particular parties.
Canadian competent authority has stated(25) that Canada has endorsed the OECD proposals for transfer pricing that essentially determine an arm’s-length price for a specific transaction. There are currently no indications that Canada intends to change its transfer-pricing rules. At a recent OECD meeting, it was apparently noted that the 1979 guidelines are now outdated and there is need for revision and review especially taking into account the U.S. position. It was also recognized that there may be some amendments arising as a result of the U.S. regulations.
There is also substantial concern by the Canadian competent authority with respect to the use of the comparative profit interval and the periodic adjustment that may be required in transfer pricing. It is not certain how compatible this will be with Canadian legislation, and if the governments do not use the same base, there will be more likelihood of double taxation.
V. Advance Pricing Agreements
One method of avoiding litigation may be by an advance pricing agreement process (APA), which is now being used by the Internal Revenue Service. In effect, the APA process allows for a pre-approval of a taxpayer’s inter-affiliate pricing and cost-sharing arrangements. This voluntary process allows the taxpayer to enter into an agreement with the Office of the IRS Associate Chief Counsel (International) on the taxpayer’s transfer-pricing methodology and how that methodology will apply to price and the taxpayer’s inter-affiliate transaction.(26) The details of the advance pricing agreement are beyond the scope of this paper; however it is sufficient to note that competent authority has advised that there are two advance pricing agreements before Revenue Canada for approval at this time. One of these is in an advanced stage.
VI. Conclusion
Canadians have enjoyed significant success in settling pricing disputes, notwithstanding the vagueness of the underlying legislation. Mostly, this success is due to the willingness of Revenue Canada in general and Competent Authority in particular to negotiate realistic settlements. The same attitude has been applied by the Canadian courts in order to reach common sense solutions. The paucity of reported cases suggests that the Canadian arm’s-length standard has worked reasonably well. The proposed section 482 regulations deviate from the arm’s-length standard by moving several degrees from reality and requiring backward adjustments. Based on recent comments by senior IRS and Treasury officials, it is likely the regulations will be substantially revised. If they are not, the likelihood is that there will be more double taxation situations. Resolution of the resulting conflicts may be even beyond the ability of competent authority if Canada and the rest of the world continue to use the international norm of the arm’s-length standard. (1) RSC 1952, c.148, as amended by SC 1970-71-72, c.63, and as subsequently amended. See also subsections 15(1) and 214(3), which together impose Canadian withholding tax on shareholder benefits. (2) For purposes of the Act, the determination of whether parties deal at arm’s length is a question of fact; persons who are defined to be related to each other, however, are deemed not to deal at arm’s length. See section 251. (3) See subsections 69(1) and (2), which apply fair market value tests to domestic transactions. The difference in wording suggests a broader range of values (including fair market value) may be applicable in the international context. See Information Circular 87-2, at [paragraph] 7, which appears to accept this view. (4) See Committee on Fiscal Affairs of Organisation for Economic Cooperation and Development, Report on Transfer Pricing and Multinational Enterprises (1979). (5) Revenue Canada Audit Guidelines (Taxation Operations Manual), at 14(63)9.4. (6) Johnston v. M.N.R., [1948] SCR 486. See also Tobias v. The Queen, 78 DTC 6028 (F.C.T.D.); and First Fund Genesis Corporation v. The Queen, 90 DTC 6337 (F.C.T.D.). (7) 52 DTC 359. (8) Needless to say, a taxpayer is still well advised to assemble the best possible case for trial since he must convince the court on the balance of probabilities. (9) 61 DTC 1047 (Ex. Ct.). (10) Sub nom. No. 716 v. M.N.R., 60 DTC 365. (11) 62 DTC 50. (12) 62 DTC at 52. (13) See also Rolka v. M.N.R, 62 DTC 1394, 1405 (Ex.Ct). (14) 81 DTC 5168 (F.C.A.). (15)See also Irving Oil Ltd. v. The Queen, 91 DTC 5106 (F.C.A.). (16) 88 DTC 6053 (F.C.A.). (17) 75 DTC 5150 (F.C.T.D.), aff’d, 77 DTC 5367 (F.C.A.). (18) [1967] 1 All. E.R. 518. (19) For a general description of the competent authority process, see Information Circular 71-17R3 (Feb. 22, 1991), and John A. Calderwood, The Competent Authority Function: A Perspective From Revenue Canada, reprinted in Report of Proceedings of the 41st Tax Conference of the Canadian Tax Foundation, 1989 Conference Report, at 39:1 (1990). (20) The IRS has suffered a series of full or partial losses in major pricing cases in recent years as the Courts have refused to adopt IRS case theories. See, eg., Eli Lilly and Co. v. Commissioner, 84 T.C. 996 (1985), aff’d in part, rev’d in part, rem’d, 856 F.2d 855, 860 (7th Cir. 1988); G.D. Searle & Co. v. Commissioner, 88 T.C. 252 (1987); Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525 (1989), aff’d, 933 F.2d 1084 (2d Cir. 1991); and Sundstrand Corp. v. Commissioner, 96 T.C. 226 (1991). (21) U.S. Department of the Treasury, Section 482 White Paper on Intercompany Pricing, reprinted at 1988-2 C.B. 458. See Treas. Reg. [section] 1.482-1(b)(1). (23) See Information Circular 87-2. (24) See Prop. Reg. [section] 1.482-2(f)(1). (25) Remarks of Carole Gouin-Toussaint, Director General, International Tax Programs Directorate, Revenue Canada, Third Annual Transfer Pricing Seminar (Toronto, May 14, 1992). (26) See Rev. Proc. 91-92, 1991-1 C.B. 526.
SALVADOR M. BORRACCIA is a partner in the Toronto office of Baker & McKenzie. Mr. Borraccia has received B. Comm., LL.B., and LL.M. degrees and was formerly with the Income Tax Litigation Section of the Canadian Department of Justice.
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