The transfer pricing adjustment rules in subsection 247(2) of the Income Tax Act1 apply when transactions undertaken by non-arm's length parties do not reflect arm's length terms and conditions. One of the most difficult questions in applying a prescribed transfer pricing methodology is how to appropriately determine an arm's length price for a sort of transaction that rarely occurs between arm's length parties. In McKesson,2 the Tax Court found that an "other method" than those set out in the OECD Guidelines was the most appropriate method to use, leading to a highly technical economic analysis regarding the appropriate pricing of risk. The Court observed that the OECD Guidelines are written not only by persons who are not legislators, but are in fact the tax collection authorities of the world. The legal provisions of the Act govern and do not mandate the tests or approaches identified in the Guidelines.
McKesson was the first major transfer pricing decision to be released in Canada since the Supreme Court of Canada's decision in Canada v. GlaxoSmithKline Inc.3 The Tax Court interpreted and applied the approach of the Supreme Court in the Glaxo case, although the latter was decided under former subsection 69(2), which contained words not found in subsection 247(2), such as "reasonable in the circumstances" and "fair market value". In McKesson, Justice Boyle saw no compelling reason for a different approach. As he noted:
In GlaxoSmithKline, the Supreme Court determined that in deciding transfer pricing disputes, the court must take into account all transactions, characteristics and circumstances that are relevant in determining whether the terms and conditions of the transactions in question are different from what arm's length parties would have agreed. In that case, the Court determined the economic conditions that resulted from the taxpayer's other agreements with its non-arm's length counter-party were relevant to the transfer pricing analysis.
Pricing of Risk
In McKesson, the taxpayer, McKesson Canada Corporation ("McKesson Canada"), had undertaken a series of transactions whereby it sold a portion of its accounts receivable to its direct parent company. McKesson Canada was the principal Canadian operating entity in the international group of companies owned by McKesson Corp. ("McKesson U.S."), a U.S.-resident corporation.
The group's core business was the wholesale distribution of over-the-counter and prescription pharmaceuticals. In 2002, McKesson Canada entered into a receivables purchase agreement (the "RPA") with McKesson International Holdings ("MIH"), its Luxembourg parent, under which McKesson Canada sold its receivables to MIH at a discount from the face amount of the receivables.
At the time the RPA was entered into, McKesson Canada had sales of $3 billion and profits of $40 million, credit arrangements with major financial institutions in the hundreds of millions of dollars, a sizeable credit department that collected the receivables within 30 days (on average) and a bad debt experience of only 0.043%. There was no evidence of pending imminent or future change in the makeup, nature or quality of McKesson Canada's receivables or customers.
At the time, McKesson Canada had not identified a business need for a cash infusion or borrowing, nor did McKesson Group need its Canadian subsidiary to raise funds for another member of the group. Most of the proceeds of the initial $460 million receivables sale were returned by McKesson Canada to its non-resident shareholder, while a portion was loaned for some time to another Canadian corporation to permit its tax losses to be used. About 1% of the proceeds were used by McKesson Canada for its general corporate purposes.
Prior to the RPA, McKesson Canada was profitable, but the Tax Court noted that as a direct result of the discount provided by McKesson Canada on the receivables sale, McKesson Canada ceased to be profitable and reported a tax loss during the tax year at issue. The company's profits in subsequent tax years were significantly reduced as well. Under the RPA, the parties applied a Discount Rate of 2.206% to the face value of the receivables (the "Discount Rate"), meaning that MIH would acquire the receivables portfolio for their face value less the Discount Rate. McKesson Canada continued to collect the receivables from its customers on behalf of MIH. For servicing the receivables, McKesson Canada received an annual fixed fee of $9,600,000.
The CRA applied a Discount Rate of 1.013%, resulting in a transfer pricing adjustment for the year at issue of $26.6 million.5
Numerous factors were considered in supporting the Discount Rate arrived at by both sides. The Court reviewed the various expert reports and witness testimony in great detail. It was clear that McKesson Canada lacked a business purpose for factoring its receivables and that the primary purpose of the transaction was to reduce profits and create losses in order to obtain a tax benefit:
However, the Court went to great lengths to consider the various expert reports diligently and logically, without overlaying a moralistic approach:
The Honourable Justice Boyle, who prior to his judicial appointment was a member of the CRA's GAAR and Transfer Pricing Review Committees, is evidently highly proficient with the various economic principles espoused in the experts' reports and accepted nothing at face value. His written decision contained an almost unprecedented level of detailed economic analysis with no assumption left unquestioned.
In the end, the Tax Court did not accept the conclusions of any one of the experts or their reports in their entirety. The Court rejected or found unpersuasive various parts of the experts' analyses while relying on other parts. To summarize its overall approach, the Court was of the view that:
The Court found less helpful the approach taken by experts that involved beginning with a "comparable" but fundamentally different transaction from the receivables sales agreement (the "RSA"), and layering on various assumptions and adjustments in order to come to an economically equivalent transaction. Rather, the Court attempted to determine the appropriate range of Discount Rates based on the value of the risk accepted by MIH, given the terms and conditions of the RSA, the composition of the receivables portfolio, McKesson Canada's collections history and the relevant external factors (such as McKesson Canada's position within the McKesson Group).
In reviewing the transfer pricing approaches taken by the various experts, the Court had to consider the impact of certain factors that existed only because of the arm's length relationship between the parties. Taxpayers have argued in various cases that section 247 of the Act requires the Court, in applying an arm's length test, to assume away factors that exist only because of the non-arm's relationship between the parties. For example:
Citing Alberta Printed Circuits10 and the approach taken in G.E. Capital,11 the Court concluded that "all circumstances, including those that derive from or are rooted in the non-arm's length relationship should be taken into account." In fact, to do otherwise would be to permit companies within wholly-owned groups to enter into "skeletal agreements" conferring few rights, with a view to obtaining a more favourable transfer price for the non-resident and reducing taxes for the Canadian taxpayer.12
After extensive review of the expert reports, testimony and his own analysis, Justice Boyle agreed with the CRA that the Discount Rate set by the RSA was excessive. He found that the appropriate range was 0.959% to 1.17% and as a result, the CRA's key assumption of fact supporting the CRA's reassessment (that the arm's length Discount Rate was 1.0127%) had to be accepted. The CRA's assumption did not have to be proven correct; rather, the onus was on the taxpayer to establish with sufficient credible and reliable evidence that the CRA's assumed rate was incorrect:
Further, the Court said it would be inappropriate for it to order the Minister to reconsider and assess at the high end of the range of arm's length Discount Rates (1.17%).
The Court also took the taxpayer to task for failing to properly support the Discount Rate through a contemporaneous transfer pricing study, notwithstanding that it subsequently made extensive efforts to shore up its position once the CRA had challenged it:
Justice Boyle did not pull punches against anyone involved in the trial. The CRA should review its policy regarding what is acceptable as "contemporaneous documentation;" the Crown shifted its position "a fair bit" in the course of the trial; and the testimony and reports that were submitted to support the Discount Rate were flawed – "significant shortcomings" in one report lead "one to think that [it] was primarily a piece of advocacy work, perhaps largely made as instructed," and a particular expert was "quick to point out the specks in [opposing] expert reports, and downplaying, if not refusing to acknowledge, the weak points in his own."
One can sense Justice Boyle's raised eyebrows regarding the process undertaken by the taxpayer (or rather, by its U.S. parent and tax advisors) in structuring the RSA transactions. In particular, Justice Boyle noted the relevant agreements were first signed as of December 16, 2002, and the planning, structuring and drafting clearly had been in progress for a significant period of time before that. The process was led by McKesson U.S.'s vice president in charge of tax, together with tax and banking lawyers at its Canadian law firm. Justice Boyle commented that it appears McKesson Canada, the taxpayer's involvement was minimal and limited to providing support and information regarding such things as its customers, receivables portfolio and credit and collections policies.
Only about two weeks before the agreements were signed, Toronto Dominion Securities Inc. ("TDSI") was engaged to provide advice on certain arm's length aspects of the terms and conditions of the RSA and certain components of the discount calculation. It was clear that TDSI was consulted only after the structure and pricing were settled and that any advice or information given by TDSI did not result in any significant changes. Further, the TDSI executive handling the analysis was a securitization expert and was not (nor did she profess to be) an expert regarding the pricing of risk in a receivables factoring transaction. Despite that, TDSI's opinions were relied on as the taxpayer's only contemporaneous documentation. While acknowledging that the executive who prepared the TDSI opinion was certainly an expert in securitization transactions and that her testimony was helpful to the Court, the purpose, objective and characteristics of the RSA transactions were "significantly and materially different than a securitization transaction."16 It appears to have given the Court pause that TDSI was apparently merely hired to bless a structure that had already been decided upon.
As an aside, the Court commented that given the TDSI reports were the sole contemporaneous documentation provided by the taxpayer to successfully contest the CRA's pre-assessment proposal to impose transfer pricing penalties, the CRA might need to review its threshold criteria: "I would not have expected last minute, rushed, not fully informed, paid advocacy that was not made available to the Canadian taxpayer and not read by its parent, could easily satisfy the contemporaneous documentation requirements."17 The Court also referred to a report by PricewaterhouseCoopers ("PwC"), which was prepared to respond to the CRA auditor's review of the RSA transactions. As the PwC report was not supported by witness testimony, Justice Boyle stated he could give it little weight, except to the extent that it may have corroborated the approaches taken by others. It appeared that the PwC report was largely dismissed as a piece of advocacy work.
This comes as something of a shot across the bow regarding contemporaneous documentation requirements. The Tax Court lingered on the qualifications of the professionals whose reports were used as the contemporaneous documentation, the quality and relevance of their analysis, whether they are experts regarding the particular type of transaction and the degree of involvement and input they had in the design of the transaction. Although the Court was, overall, complimentary regarding TDSI's approach in reviewing and commenting on the pricing of the Discount Rate, the Court appears to have objected to the apparent fact that TDSI seems to have been hired to tick a box on a tax planner's to-do list, rather than to provide any meaningful input regarding the transaction.
The Court also referred in some detail to the testimony of the McKesson Group's VP of Tax regarding the group's various other tax planning strategies, including a double-dip financing structure between Canada and the U.S. and what sounds like a Double Irish structure (such as has been attributed in the press to Apple and Microsoft). It was somewhat unclear what relevance this had to the transfer pricing issue at hand. Possibly the Court viewed the McKesson Group's global tax planning strategies to be part of the "overall picture," given that such planning may have enabled MIH to utilize funds that had borne little or no foreign tax for the purpose of acquiring the receivables portfolio from McKesson Canada. Although the Court recognized that the RSA (and other tax strategies) were clearly put in place to minimize global tax, this was acceptable – the Court's responsibility was only to ensure the transaction was completed on arm's length terms.
Treaty Limitation Period and Secondary Adjustment
The CRA also assessed McKesson Canada for its failure to withhold and remit on the benefit it gave to MIH via the transfer of the receivables for too little consideration. Part XIII imposes withholding tax of 25% on shareholder benefits that are deemed to have been paid as a dividend to the non-resident shareholder. The Canada-Luxembourg Treaty ("Treaty") reduced the withholding tax to 5% on the deemed dividend.
The transfer pricing reassessment of McKesson Canada was issued by the CRA on March 25, 2008. The secondary assessment under Part XIII was issued to McKesson Canada on April 15, 2008. The CRA did not ever assess MIH directly under Part XIII. McKesson Canada argued that the five calendar year limitation rule in Article 9(3) of the Treaty prohibited the secondary adjustment. Although the CRA had reassessed McKesson Canada under the primary transfer pricing adjustment within the five-year period, the secondary withholding tax assessment was several weeks late.
The Court interpreted the meaning of Article 9 and concluded that the limitation period in paragraph 3 did not apply to the secondary adjustment of McKesson Canada. The Court acknowledged that under the Vienna Convention and the Supreme Court's decision in Crown Forest,18 "literalism has no role to play in the interpretation of treaties ..."19 In ascertaining the purposes of a treaty, the Court may refer to extrinsic materials which form part of the legal context, including model conventions and official commentaries thereon, without first needing to find ambiguity in the wording of the treaty provision.
However, the Court found the secondary assessment, by its nature, did not fit within the wording of Article 9(3). Specifically, the vicarious liability assessment of McKesson did not fit within the words of Article 9(1), so the limitation period in Article 9(3) could not apply.
The Court specified that to fit within the words of Article 9(1), the following requirements would have needed to be met:
(i) The assessment of McKesson Canada must be a change in the income of MIH.
(ii) The adjustment of MIH's income must be in the following circumstances:
a. MIH controls McKesson Canada or both are controlled by McKesson U.S.;
b. the conditions between MIH and McKesson Canada differed from the conditions that would have been made between arm's length parties;
c. the income adjustment is income that would have accrued to MIH, not McKesson Canada, but for the non-arm's length conditions; and
d. Canada sought to add the income adjustment to MIH's income and tax it accordingly.
(iii) To obtain the relief sought under Article 9(3), a period of five years must have passed since the end of the year in which the income of MIH that Canada sought to change would have accrued to MIH (but for the non-arm's length conditions).
The Court found that the assessment of McKesson Canada under subsection 215(6) did not constitute Canada seeking to add a transfer pricing adjustment to MIH's income (according to requirements (i) and (ii)(d)). Rather, the Court viewed subsection 215(6) as an enforcement and collection provision, which did not affect MIH's income.
In addition, the transfer pricing adjustment which did occur (the change in the Discount Rate) resulted in an addition to McKesson Canada's income, not the income of MIH (failing to meet requirement (ii)(c)).
The Court found, further, that its decision was in accordance with the policy behind the Treaty, which is to avoid double taxation. The Court stated there was no evidence to indicate that the secondary adjustment resulted in any income tax for MIH in Luxembourg, and even if there was, then it was up to MIH to claim whatever relief was available to it in Luxembourg (regarding which the Court had no evidence).
With respect, the Court's interpretation that the assessment must be an "addition to MIH's income" in order to fall within Article 9(1) (and therefore Article 9(3)) is not obvious from the reading of Article 9(3). In a typical transfer pricing adjustment, the CRA would add an amount to the Canadian taxpayer's income, rather than the non-resident's income. Paragraph 2 of Article 9 requires the other Contracting State (Luxembourg) to provide an adjustment to the income of its resident (MIH) in order to avoid double taxation.
Further, if Article 9(3) is predicated on an addition to the income of the non-resident (MIH), the decision does not seem to acknowledge that the taxpayer's vicarious liability under subsection 215(6) is predicated on there being a non-resident tax liability under Part XIII for the deemed receipt of a dividend:
Although the CRA did not formally assess MIH with respect to the Part XIII tax on the deemed dividend income, the tax assessment under subsection 215(6) is still arguably a tax on the non-resident on income that it is deemed to have received.
With respect, in focusing on whether Canada was directly taxing MIH and in expressing its doubt that MIH was taxable in Luxembourg on its income, the Tax Court did not seem to give full consideration to the point that non-residents normally claim foreign tax credits for withholding tax paid by them in Canada, which is paid and remitted by the Canadian payer on the non-resident's behalf. McKesson Canada could claim indemnity from MIH for the Part XIII tax after the five-year period had passed. However, MIH may effectively have been barred from claiming any foreign tax credit relief in Luxembourg under the latter's domestic limitation periods. In fact, under Article 23(2)(c) of the Treaty, dividends distributed by a Canadian company to a Luxembourg parent are required to be exempted from income for purposes of Luxembourg income tax.
A liberal interpretation of the purpose of Article 9(3) is, perhaps, that it does not only put a limit on the period during which the non-resident person may seek to adjust its income in the other Contracting State (under Article 9(2)), but also to permit the other Contracting State (Luxembourg, in this case) to reasonably put a limit on having to grant foreign tax credits or a tax exemption.
The counter-argument to this point of course, is that the Treaty does not contain a limitation period with respect to the assessment of withholding tax permitted under Article 10 (Dividends). Canada may, therefore, arguably assess Part XIII tax on a dividend paid (or deemed to be paid) to a non-resident person at any future time whatsoever, leaving the non-resident at the mercy of its own country's domestic limitation periods.20
The McKesson ruling was a definite win for the CRA and Canada's Department of Justice after the loss in the GlaxoSmithKline case and serves as a warning to multinational enterprises that are considering tax-motivated receivables factoring transactions with related parties. The expert testimony could not change the impression that McKesson Canada lacked a business purpose for factoring receivables, this transaction reduced profits and created losses and the primary purpose was to obtain a tax benefit.
There have been four major transfer pricing cases recently heard by the Canadian courts. In two of these cases, one of the two parties took a relatively aggressive position (the CRA in the G.E. Capital case and the taxpayer in McKesson) which was rejected entirely by the courts. In both GlaxoSmithKline and Alberta Printed Circuits, the parties both took somewhat more reasonable, balanced positions. In those cases, the courts arrived at a conclusion that was somewhere between the two parties' positions.
The Court's comments in McKesson may also lead to greater scrutiny of contemporaneous documentation; ideally, taxpayers will obtain qualified expert transfer pricing advice regarding their proposed non-arm's length transactions during the planning stages, while changes can be made to reflect the expert advice.
Although the McKesson decision was extraordinarily lengthy and contained a great deal of difficult and complex analysis, it included nuggets that were decidedly intended for the amusement of the reader – as in the following postscript offered by Justice Boyle:
On January 10, 2014, McKesson Canada filed a notice to appeal the Tax Court's ruling to the Federal Court of Appeal.
1 R.S.C. 1985, c. 1 (5th Supplement), as amended, hereinafter referred to as the "Act." Unless otherwise stated, statutory references in this article are to the Act.
2 McKesson Canada Corporation v. The Queen, 2013 TCC 404.
3 2012 SCC 52.
4 Supra note 2 at paragraph 121.
5 The taxation year at issue was a short year of approximately 3 ½ months.
6 Supra note 2 at paragraph 275.
7 Ibid. at paragraph 167.
8 Ibid. at paragraph 270.
9 Ibid. at paragraph 129.
10 Alberta Printed Circuits v. The Queen, 2011 TCC 232.
11 General Electric Capital Canada Inc. v. H.M.Q., 2011 DTC 5011.
12 Supra note 2 at paragraph 132.
13 Ibid. at paragraph 355.
14 Ibid. at paragraph 357.
15 Ibid. at paragraph 246.
16 Ibid. at paragraph 53.
17 Ibid. at paragraph 50, footnote 20.
18 The Queen v. Crown Forest Industries Limited et al., 95 DTC 5389.
19 Coblentz v. The Queen, 96 DTC 6531 (F.C.A.).
20 For an excellent review of the secondary adjustment analysis and its potential broader implications, see Jim Wilson and Ingrid De Freitas, "McKesson Canada Corporation v. The Queen – Making Secondary Adjustments a Primary Concern After Treaty Time Limits Have Passed," Canadian Tax @ Gowlings, Volume 11, Number 2, May 12, 2014 (available on www.gowlings.com).
21 Supra note 2 at paragraph 397, footnote 82.
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