On June 10, 2014, the Tax Court of Canada ("TCC") delivered its most recent decision on transfer pricing, one which involved a Barbados structure. In Marzen Artistic Aluminum Ltd. v. The Queen1 ("Marzen"), Justice Sheridan upheld the Canada Revenue Agency's ("CRA") transfer pricing adjustment as well as the penalty under subsection 247(3) of Canada's Income Tax Act ("Act"). The timing of the Marzen decision is of particular interest when you consider the ongoing work by the Organisation for Economic Co-operation and Development ("OECD") on base erosion and profit shifting ("BEPS").2 The Marzen case provides a perfect example of what would appear to be a tax-driven transfer pricing structure involving a low-tax jurisdiction where there is a clear separation between the location of substantive business activities and the jurisdiction where taxable profits are reported. This type of structure, although designed with the intention of being legally effective, is the very issue that the OECD and G20 are trying to rectify.
Summary of the Marzen Decision
The Taxpayer was a company resident in Canada that designed, manufactured and sold aluminum and vinyl windows in Canada. Starline Windows Inc. ("SWI"), a United States tax resident in the Taxpayer's group of companies, was set up in 1998 to expand the Taxpayer's business in the U.S. SWI purchased window products from the Taxpayer at a price that provided a margin of 15% to 18%. SWI personnel solicited orders for window products from U.S. customers. SWI's initial focus on the Washington residential market proved unsuccessful.
The Taxpayer was eventually referred to Mr. David Csumrik, a resident of Barbados, as a person who could help develop a marketing strategy. Mr. Csumrik determined that the Taxpayer was focused on the wrong U.S. market and advised it to shift its marketing efforts to certain Canadian developers who were active in the highrise market in southern California ("game-changing idea"). In 1999, following Mr. Csumrik's advice, the Taxpayer set up the "Barbados Structure".
Mr. Csumrik's personal company, Longview Associates Limited ("Longview"), assisted the Taxpayer in setting up a wholly-owned subsidiary in Barbados, an International Business Corporation ("SII"), to act as a marketing and sales company. SII had no assets or employees other than Mr. Csumrik, who served as a part-time managing director. Longview was engaged by SII to provide typical corporate services and was compensated USD 30,000 per year by SII for those services. In addition, Mr. Csumrik received an annual fee of USD 2,500 for his personal services as managing director of SII.
The related parties then entered into several intercompany agreements, the key agreement being a marketing and sales services agreement ("MSSA") between the Taxpayer and SII, which set out the fee structure. The MSSA stated that the Taxpayer would pay SII the greater of $100,000 or 25% of sales. In addition, the MSSA was ultimately amended to provide that the Taxpayer would pay SII a one-time bonus of 10% on all confirmed contracts in the California market on condition that SII achieve at least US$10 million in net sales within a certain time period. These conditions were ultimately met and the bonus ultimately paid.
SII and SWI entered into two agreements, the first being a personnel secondment agreement ("PSA") whereby SWI agreed to provide the services of personnel on an exclusive basis to be retained by SII in the marketing of the Taxpayer's products. SWI's compensation under the PSA was a monthly fee intended to cover SWI's costs of the personnel plus a nominal service fee of 10%. The second agreement was an administrative and support services agreement ("ASSA"), whereby SWI agreed to provide secretarial and other administrative support services to SII for a monthly fee.
In effect, the arrangement allowed the Taxpayer to generate most of its profits from U.S. sales in Barbados (i.e., profit shifting from high tax jurisdiction to low tax jurisdiction). In 2000 and 2001, the Taxpayer paid in aggregate $12,005,633 to SII under the MSSA. These payments were fully deducted by the Taxpayer in computing its Canadian business profits. SII, being an International Business Corporation, paid nominal income tax in Barbados on the profits. As a foreign affiliate of the Taxpayer, SII then declared dividends to the Taxpayer who received the dividends free of Canadian income tax.
The CRA issued notices of reassessment which disallowed the fees paid by the Taxpayer to SII under the MSSA that were in excess of the $4,869,941 in fees paid by SII to SWI during this period on the basis that they were not in accordance with the arm's length principle.
Counsel for the Taxpayer argued that the TCC must consider both the direct services performed by SII under the MSSA and the indirect services performed by the SWI employees under the PSA in determining whether the compensation paid by the Taxpayer to SII under the MSSA was in accordance with the arm's length principle. The Taxpayer's counsel and expert witness argued that the TCC should be viewing the situation as an "amalgam", that is, SWI and SII should be viewed as a single entity. They also maintained that SII, through the efforts of Mr. Csumrik, undertook substantial collaborative efforts with SWI, through ongoing supervision and advice, to fulfill its obligations under the MSSA. Finally, the Taxpayer argued that "proof was in the pudding", in that the fees under the MSSA were justified because the Taxpayer achieved significant increases in U.S. sales shortly after the structure was put in place.
The Crown's position focused on the lack of services provided by SII to the Taxpayer that could warrant the significant compensation under the MSSA. The Crown seemingly conceded that Mr. Csumrik came up with the game-changing idea. However, as confirmed by the relevant parties, Mr. Csumrik was to be compensated for this idea under a separate "handshake" agreement with the Taxpayer's owner and therefore this should not be a relevant factor in determining the arm's length compensation for services rendered by SII to the Taxpayer under the MSSA. Fifteen years after sharing his game-changing idea, Mr. Csumrik had still not been paid under the handshake arrangement. The Crown noted that the Taxpayer's emphasis on the value of Mr. Csumrik's contribution to SII's marketing performance to justify the fees paid to SII by the Taxpayer supported the Crown's argument that it was unreasonable that Mr. Csumrik would accept minimal compensation, that is, $2,500 per year, for such services. In addition, if, as the Taxpayer alleged, Mr. Csumrik's real incentive for creating such value for SII was a separate handshake agreement, that begs the question of what the Taxpayer paid SII the fees for.
Even though Mr. Csumrik was credited with the game-changing idea, it was ultimately determined during the trial that Mr. Csumrik had no contacts or relationships with the Canadian developers. Therefore, any substantive contribution Mr. Csumrik made to the ultimate success of the Taxpayer's business expansion in the U.S. ended when he presented the game-changing idea. The TCC effectively squashed any relevance to this factor, by concluding that Mr. Csumrik provided this advice in his personal capacity directly to the Taxpayer's owner before the actual intercompany agreements and Barbados Structure were put in place. Consequently, no part of the MSSA fees was intended to compensate SII for Mr. Csumrik's game-changing idea.
The TCC also dismissed the "amalgam" argument, finding that many of the assumptions in the Taxpayer's expert report regarding Mr. Csumrik's involvement under the MSSA were unfounded and that treating SWI and SII as one entity contravened the arm's length principle as described in the OECD Transfer Pricing Guidelines.3
The TCC's ultimate focus then shifted to the substance of the activities performed by Mr. Csumrik in his role as managing director for SII in allowing SII to fulfill its obligations to the Taxpayer under the MSSA. Mr. Csumrik's credibility was brought into question by the TCC, as there were discrepancies between his sworn evidence at trial and written representations that he provided to the CRA at the audit stage regarding his role in SII. The TCC recognized that Mr. Csumrik, on behalf of SII, "provided some on-going direction to the SWI sales team by way of reviewing sales reports and providing some strategic advice and suggestions to SWI on behalf of SII [...] However, the performance of most such services overlapped with the functions he performed in his capacity as managing director of SII through Longview." Ultimately, the TCC agreed with the Crown's argument that SII "was an empty shell with no personnel, no assets and no intangibles or intellectual property." Despite the Taxpayer's "proof is in the pudding" argument, the TCC found "that the financial results achieved under the Barbados Structure [...] do not, in themselves, justify the fees paid under the MSSA and the MSSA Bonus Payment Agreement."
Finally, the TCC found that that the terms and conditions of the MSSA were not consistent with the arm's-length principle. The TCC held that the compensation paid by SII to Longview and Mr. Csumrik for corporate services and director fees was a comparable uncontrolled price ("CUP"), a transfer pricing methodology, for the services ultimately provided by SII to the Taxpayer. In other words, the Court concluded that an arm's length party would have paid an amount to SII that exceeded the fees paid by SII to SWI (i.e. $4,869,941), but only in the amount of USD $32,500 per year. The TCC also upheld the penalty under the Act because the $5 million threshold was met and the Taxpayer failed to make reasonable efforts to determine and use arm's-length transfer prices in 2001.
There are several principles or takeaways that can be gleaned from the Marzen decision. First, legally effective contracts are not, in and by themselves, justification for the compensation paid between related parties. It is imperative that contractual arrangements between related entities have substance and provide real value. It is a fundamental transfer pricing principle that a detailed analysis of the substantive nature of the functions performed by the service provider must be conducted before the arm's length compensation for those services can be determined. The current work by the OECD on BEPS only emphasizes the importance of identifying the substantive business activities being performed.
Another takeaway from the Marzen decision is the importance of maintaining proper contemporaneous documentation regarding intercompany transactions. In Marzen, the Taxpayer merely "ballparked" its transfer prices and made a superficial attempt at documenting the assumptions, strategies and policies that influenced its determination of the relevant transfer prices. Consequently, the TCC upheld the CRA's application of transfer pricing penalties.
Also, the TCC referred to the OECD Transfer Pricing Guidelines on specific issues, noting their acceptance by Canadian courts as an interpretive tool, and supported the use of the CUP transfer pricing methodology when appropriate.
The final takeaway from Marzen, and perhaps the most important from a tax advisor's perspective, is the importance of properly implementing tax driven arrangements. While simply altering a few characteristics of the Barbados structure may not have been sufficient to justify the magnitude of the profit shift from Canada or the U.S., as the case may be, to Barbados, it could have raised some interesting considerations for the TCC and potentially resulted in a different outcome for the Taxpayer. Consider, for example, the following hypothetical facts:
- Mr. Csumrik's or Longview's compensation from SII was actually dependent on the Taxpayer's ultimate success in the U.S., that is, beyond a handshake agreement to compensate Mr. Csumrik at a future time;
- The "game-changing idea" was brought to the Taxpayer's attention by SII after the Barbados structure was set up and the intercompany agreements were in place; and
- SII seconded a key employee from SWI to reside in Barbados and work on the MSSA under Mr. Csumrik's leadership.
However, the Taxpayer never rewarded Mr. Csumrik for the game-changing idea beyond contracting with his personal company to provide routine manager/director services to SII. This was ultimately a significant factor in allowing the TCC to discard the Taxpayer's "proof is in the pudding" argument and conclude that compensation to SII should be limited to that of "a flow-through entity or facilitator that makes the services of others available to the [Taxpayer]."
The timing of the Marzen decision is of particular interest when you consider the work being done by the OECD on BEPS. The TCC's reasons in Marzen were decisively in favor of the CRA's application of the arm's length principle, factoring heavily on the profit-shifting nature of the Barbados structure and the complete lack of substantive people functions being performed in Barbados by SII. Some may argue that Marzen is proof that the current OECD Transfer Pricing Guidelines adequately enable tax administrations to successfully challenge tax-driven structures, and therefore all the hype surrounding BEPS, at least from the transfer pricing components of the OECD's Action Plan, is unnecessary and simply a ploy to address public perception. However, the reality is that the Marzen case dealt with a simple intercompany transaction involving marketing services, whereas the tax driven structures targeted by the OECD under their transfer pricing actions are mostly complex scenarios not adequately addressed by the Transfer Pricing Guidelines, particularly involving intellectual property and financing issues. Consequently, it is the author's view that cases like Marzen only support the concerns that instigated the G20 and the OECD's work on BEPS and that any OECD measures which reduce the effectiveness of aggressive tax driven structures, such as new revisions to the OECD Transfer Pricing Guidelines, are justifiable and warranted.
It is unfortunate, however, that the Internal Revenue Service did not get involved in this file regarding the issue of whether the total profits earned by SWI for its functions performed in the U.S. under the Barbados structure was in accordance with the arm's length principle. The CRA, for obvious reasons, had accepted that the fees paid by SII to SWI were in accordance with the arm's length principle, therefore justifying that all remaining profits should be taxed in Canada. But in the author's opinion, and in the absence of further facts, that issue is not without doubt, particularly when you consider that under the pre-Barbados structure in 1998, when SWI incurred losses due to low U.S. sales, SWI was purchasing window products from the Taxpayer at a price which would provide a margin of 15-18%. The Barbados structure had SWI being compensated, for the most part, on a cost plus 10% transfer pricing methodology as a service provider.
Finally, it is worth noting that the Taxpayer has appealed the TCC's decision to the Federal Court of Appeal. So certainly there will be more to come on this case.
1. Marzen Artistic Aluminum Ltd. v. The Queen (2014 TCC 194).
2. On July 19, 2013, the OECD published a 15 point action plan ("Action Plan") to address issues in international tax rules pertaining to BEPS.
3. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, August 18, 2010.
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