Tucked away in the deep recesses of the Income Tax Act (the ‘‘Act’’), 2 obscured by the long shadows cast by the neighbouring general anti-avoidance rule in section 245 of the Act (the ‘‘GAAR’’), is paragraph 247(2)(b), 3 an arcane recharacterization rule whose genesis, purpose and ambit are shrouded in mystery. The purpose of this article is to demystify paragraph 247(2)(b) and thereby (hopefully) provide some much needed guidance to practitioners and the Canada Revenue Agency (the ‘‘CRA’’) alike in terms of that provision’s intended application.
The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations were extensively revised in 1995 (the ‘‘Revised Guidelines’’). The Revised Guidelines provide that, in exceptional circumstances, it is permissible for tax administrators to recharacterize or reconstitute transactions themselves, rather than merely adjust the terms of such transactions:
In other than exceptional cases, the tax administration should not disregard the actual transactions or substitute transactions for them . . . However, there are two particular circumstances in which it may, exceptionally, be both appropriate and legitimate for a tax administration to consider disregarding the structure adopted by a taxpayer in entering into a controlled transaction. 4
These statements in the Revised Guidelines served as the Department of Finance’s ‘‘authority’’ for enacting the recharacterization rule in paragraph 247(2)(b). In other words, but for these statements, paragraph 247(2)(b) would not have been enacted. Accordingly, paragraph 247(2)(b) is not intended to apply in circumstances other than those identified in the Revised Guidelines. 5
As noted, the Revised Guidelines set forth two circumstances where expenses it is permissible for tax authorities to proceed in this exceptional manner.
The first circumstance is where the form of the transaction belies its substance. The example provided in the Revised Guidelines is the making of a loan by a taxpayer a non-arm’s length person, where, having regard to the economic situation of the borrower, the investment appears to be an economic substitute for share capital. The Revised Guidelines are thus alluding to a thin capitalization type situation. 6 Another example of this first circumstance (albeit outside of the transfer pricing context) is provided by the Imperial Oil case. 7 In that case, the taxpayer lent money to a non-bank subsidiary of a bank, on the strength of the bank’s loan guarantee. The taxpayer lent the money in this manner, rather than directly to the bank, because a loan to a bank would not have given rise to an investment allowance for capital tax purposes. Therefore, while the transaction’s legal form was a loan to a subsidiary of a bank, its economic substance was, arguably, a loan to a bank.
The Department of Finance and the CRA considered whether the new transfer pricing rules should apply to these types of transactions, i.e., transactions where the form belies the substance, and concluded that they should not, as such transactions were more appropriately dealt with by specific anti-avoidance rules or the GAAR. In arriving at this conclusion, consideration was given to the relationship between transfer pricing rules, on the one between hand, and specific anti-avoidance rules and the GAAR, on the other hand. It was determined that transfer pricing rules were not intended to bolster or supplement specific anti-avoidance rules, 8 since this would create uncertainty as to the application of those rules and would effectively permit the CRA to bypass or supplant the protections afforded taxpayers by subsection 245(4). More specifically, it was felt that the types of transactions described by the first circumstance should not be recharacterized, unless they constituted a misuse of the provisions of the Act or an abuse of the Act when read as a whole within the meaning of subsection 245(4) (the ‘‘misuse or abuse’’ tests). 9 Indeed, to apply the transfer pricing rules in this ‘‘substance versus form’’ context would usurp the role of the GAAR and render subsection 245(4) virtually meaningless in those situations (but only those situations) where the transaction or series involves a non-arm’s length non-resident. Plainly, this was not the result sought by Finance in enacting paragraph 247(2)(b).
That paragraph 247(2)(b) is not intended to apply in this context is confirmed by the wording of the provision itself, which, as explained more fully below, does not seek to ascertain if a particular transaction or series is a substitute for a different, arm’s length transaction or series, but rather whether the particular transaction or series has no such arm’s length substitutes. That wording is as follows:10
(b) the transaction or series
(i) would not have been entered into between persons dealing at arm’s length . .
Consequently, transactions contemplated by the first circumstance are not intended to come within the ambit of paragraph 247(2)(b). This means, for example, that, even if the Act did not contain any thin capitalization rules, paragraph 247(2)(b) would not serve as a basis to recharacterize loans made by non-arm’s length non-residents to resident corporations or trusts.
The second circumstance contemplated in the Revised Guidelines has two components. Firstly, the transaction must be one that, when viewed as a whole, would not have been one that would have been entered into by independent enterprises behaving in a commercially rational manner. In other words, the transaction must be one that is manifestly contrary to the commercial interests of the tested party. Secondly, the transaction must have been structured in this commercially irrational manner in order to impede the tax authorities’ ability to determine an arm’s length price under ‘‘normal’’ transfer pricing rules or to achieve some other tax benefit for the tested party. The application of normal transfer pricing rules is impeded because there are no arm’s length comparables upon which to base a transfer pricing assessment.11
The two-part test in paragraph 247(2)(b) is intended to parallel the above-described two-part test in the Revised Guidelines.12
The example given in the Revised Guidelines is that of the current sale by a taxpayer for a lump sum amount of all future intellectual property (in contradistinction to existing intellectual property) developed by the taxpayer in a subsequent period. This same example is discussed at paragraphs 150 and 151 of Information Circular 87-2R, which deals with international transfer pricing:
150. As outlined in paragraph 43 of this circular, the Department generally accepts business transactions as they are structured by the parties. However, the OECD Guidelines identify two types of situations where the recharacterization of a transaction would be considered. One situation identified by the OECD is a sale under a long-term contract, for a lump-sum payment, of unlimited entitlement to intangible property arising as result of future research.
151. The Department will review any long-term agreements between non-arm’s length parties for the right to use intangibles to ensure that they are consistent with the arm’s length principle. Paragraph 247(2)(b) provides for an adjustment where the Department determines that:
- a long-term sale of intangible property would not have been entered into between persons dealing at arm’s length; and
- the sale was not entered into primarily for bona fide purposes other than to obtain a tax benefit.
For example, it may be appropriate in such a situation for the Department to modify the amounts for purposes of the Act on the basis of an alternative transaction whose form, nature, terms, and conditions correspond to what arm’s length parties would have agreed to — to reflect an ongoing research agreement.
The specific reason this particular transaction may be recharacterized is touched on at paragraph 1.10 of the Revised Guidelines: ‘‘For example, an independent enterprise may not be willing to sell an intangible (e.g. the right to exploit the fruits of all future research) for a fixed price if the profit potential of the intangible cannot be adequately estimated and there are other means of exploiting the intangible’’. More specifically, absent parameters as to (i) the type of research to be conducted, (ii) the nature of the technology expected to result from the research, and (iii) the potential market for such technology, it is virtually impossible to set a price for the future technology currently agreed to be sold. Therefore, absent the above-listed circum parameters, this may be an irrational transaction in which arm’s length parties, in particular the transferor, would not participate. Conversely, if those parameters are present, the transaction should not be recharacterized, as it would be possible to adequately or rationally estimate the future technology’s profit potential.
Both the Information Circular and the Revised Guidelines state that, if recharacterization of this transaction is appropriate, then it may be appropriate to treat the transaction as a continuing or ongoing research agreement. The Revised Guidelines shed some light on what this means by noting that, notwithstanding such recharacterization, it may be proper to respect the transaction as a transfer of commercial property. 13 If the transfer of (rights to such future) property is to be respected, but it is not rational to set a fixed price therefor currently, absent the parameters listed above, then it follows that arm’s length parties would probably have agreed to the payment of a royalty by the transferee based on future revenues generated by the transferee from the resulting future property’s exploitation.
The Department of Finance and the CRA considered how the GAAR’s misuse or abuse tests would apply to this particular transaction. They concluded that the misuse test was probably irrelevant, since no specific provision of the Act was being misused. Although the abuse test was thought to be relevant, it probably did not apply either, since, based on the Stubart case, 14 the Act did not contain a general scheme against tax-motivated transactions. 15 Neither could it be said that the Act contained a general scheme against commercially irrational transactions. 16 Nevertheless, it was decided that, as a matter of tax policy, the CRA should not need to rely on the GAAR in this case, as it should be able to recharacterize such a transaction, if structured in this manner to specifically thwart the application of the normal transfer pricing rules. 17 Accordingly, it is this type of transaction, and only this type of transaction, that is intended to come within the ambit of paragraph 247(2)(b).
The specific purpose of paragraph 247(2)(b), therefore, is to ensure that the revised Canadian transfer pricing rules in section 247 of the Act can be applied in an effective manner to irrational transactions for which no arm’s length comparables exist, where the particular form of the transaction was selected by the parties to thwart the effective application of such rules to the tested party. While it was felt that the ‘‘primary’’ transfer pricing rule in paragraph if 247(2)(a) could, in theory, apply in those types of situations, it was recognized that the resulting adjustments would be too arbitrary to serve as the basis for a transfer pricing assessment, and that such an approach would effectively be playing into the hands of the taxpayer. That being said, it was also recognized that the recharacterization of a real transaction into a notional arm’s length transaction would lead to equally arbitrary results, and thus that it would be improper to use the recharacterization power in stances other than the one, exceptional circumstance identified above. This sentiment is evident in paragraphs 43 and 44 of the Information Circular:
43. The Department generally accepts business transactions as they are structured by the parties. The fact that a taxpayer has entered into a transaction with a non-arm’s length non-resident party in a form that would not exist between arm’s length parties does not necessarily imply that the transaction is inconsistent with the arm’s length principle. This may reflect the fact that parties not dealing at arm’s length operate under different commercial circumstances than do parties transacting at arm’s length.
44. There are instances where it is necessary to recharacterize a transaction for tax purposes; however, as indicated in the OECD Guidelines, those instances are limited. The OECD Guidelines identify two exceptional situations when the recharacterization of a transaction would be considered (see paragraph 1.37 of the OECD Guidelines). 18
and is echoed in the OECD’s admonition to overzealous tax administrators in this regard:
In other than exceptional cases, the tax administration should not disregard the actual transactions or substitute other transactions for them. Restructuring of legitimate business transactions would be a wholly arbitrary exercise the inequity of which could be compounded by double taxation created where the other tax administration does not share the same views as to how the transaction should be structured. 19
Hopefully, the Transfer Pricing Review Committee, which is the CRA body entrusted with ensuring the fair and consistent application of paragraph 247(2)(b) and the body to which all proposed assessments under this provision must be referred, will heed these cautionary words.
1 Although the author was a member of the Tax Legislation Division of the Department of Finance at the time the new Canadian transfer pricing rules were formulated, the views expressed in this article are entirely his own and may or may not represent the views of the Department of Finance or the Canada Revenue Agency on the matters discussed. The author would like to thank Nathan Boidman for his valuable suggestions, but is solely responsible for any errors that may have crept into this article despite the author’s best efforts.
2 R.S.C. 1985 (5th supp.), c. 1.
3 The relevant portion of subsection 247(2) is as follows:
‘‘Where a taxpayer (. . .) and a non-resident person with whom the taxpayer (. . .) does not deal at arm’s length are participants in a transaction or a series of transactions and (. . .)
(b) the transaction or series
- would not have been entered into between persons dealing at arm’s length, and
- can reasonably be considered not to have been entered into primarily for bone fide purposes other than to obtain a tax benefit,
any amounts that, but for this section and section 245, would be determined for the purposes of this Act in respect of the taxpayer (. . .) for a taxation year (. . .) shall be adjusted (in this section referred to as an ‘‘adjustment’’) to the quantum or nature of the amounts that would have been determined if, (. . .)
(d) where paragraph (b) applies, the transaction or series entered into between the participants had been the transaction or series that< would have been entered into between persons dealing at arm’s length, under terms and conditions that would have been made between persons dealing at arm’s length’’.
4 OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, OECD, 1995, at paragraphs 1.36 and 1.37.
5 Indeed, the explicit use of the arm’s length principle in subsection 247(2), the penalty provision in subsection 247(3) and the documentation requirements in subsection 247(4) were all things that Finance believed were ‘‘authorized’’ by the Revised Guidelines.
6 One can infer from the Revised Guidelines that where thin capitalization rules exist, they would apply to the exclusion of any recharacterization rules.
7 Her Majesty the Queen v. Imperial Oil Limited, 2004 DTC 6044.
8 See paragraph 21 of Information Circular 87-2R in this regard.
9 Paragraph 20 of Information Circular 87-2R states the following: ‘‘20. In addition to affecting the cross-border movement of property and services, section 247 could be applied to financial transactions. In theory, section 247 could be applied to a wide variety of arrangements resulting in foreign accrual property income to Canadian shareholders. In general, the Department considers that subsection 247(2) does not change the existing law as it relates to intercorporate debt and equity investments. The Department will usually use subsection 245(2) if the arrangement is part of an aggressive tax plan or is potentially abusive (e.g. loss importation), but could also use subsection 247(2) to challenge such an arrangement.’’ (my emphasis)
In my view, the reference to subsection 247(2) at the end of this paragraph is boilerplate.
10 See footnote 12 infra for a discussion of the ‘‘tax benefit’’ language in subparagraph 247(2)(b)(ii).
11 Note that there is an important distinction to be made between, on the one hand, transactions that are commercially irrational and, on the other hand, transactions that are commercially rational but high-risk. For example, arm’s length parties routinely make unsecured loans to thinly capitalized companies, as attested to by the existence of so-called junk bonds. The second circumstance is not intended to capture transactions that, from the point of view of arm’s length parties, are merely high-risk.
12 When first released on September 11, 1997, paragraph 247(2)(b) did not explicitly contain the wording now found in subparagraph (ii) thereof (the ‘‘tax benefit’’ test). This was because Finance initially thought that the tax benefit test was implicit in the language now contained in subparagraph (i). However, in meetings with taxpayer representatives, the point was made, with some force, that multinationals enter into all manner of transactions that have no arm’s length comparables and that a tax benefit test was needed to winnow out the ones that were acceptable from a tax policy point of view from the ones that were not. Finance agreed and paragraph 247(2)(b) was re-drafted accordingly. See, in this regard, paragraph 43 of Information Circular 87-2R and footnote 16 infra. Note that the effective circumvention of the normal transfer pricing rules in paragraph 247(2)(a) was the only ‘‘tax benefit’’ identified by Finance and CRA at the time the new transfer pricing rules were introduced.
13 OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, OECD, 1995, at paragraph 1.37.
14 Stubart Investments Ltd. v. The Queen, 84 DTC 6305.
15 Different from the approach of the Supreme Court of Canada in Canada Trustco Mortgage Co. v. R., 2005 DTC 5523, Finance approached the misuse or abuse tests in subsection 245(4) on the assumption that they were two distinct tests. A detailed discussion of subsection 245(4) is beyond the scope of this article.
16 As described in Interpretation Bulletin IT-96R6, dated October 23, 1996, the CRA employs a commercial rationality standard when assessing the appropriateness of applying section 69 of the Act (in contradistinction to section 245 of the Act) to a disposition of securities pursuant to the exercise of a call option granted to a non-arm’s length person:
17. When a taxpayer grants an option to a person with whom it does not deal at arm’s length on capital account to acquire securities of another entity, section 69 may be applied to the disposition of the securities if the price of the option and the exercise price are materially less than the fair market value of the securities otherwise determined at the time of the exercise of the option. The application of section 69 will most often apply when the taxpayer has granted a non-arm’s length "non-commercial option." A "non commercial option’’ is one into which arm’s length parties would not consider entering. For example, this type of option may involve an unrealistically long option period, a low option price, or an exercise does not fully recognize expected future events (e.g., inflation, zoning change, market trends) that affect the value of assets owned by the corporation whose securities are being optioned and thus which affect the price of the optioned securities over the option period.’’ (my emphasis)
Significantly, the CRA does not seek to apply the GAAR in these (perceived) non-commercial circumstances. The CRA’s explanation of the changes made to the prior version of paragraph 17 (viz., former paragraph 11) of the Interpretation Bulletin states that this paragraph was specifically revised to reflect the CRA’s (new) position that section 69, rather than subsection 245(2), is the relevant provision in the circumstances. Note also the similarity between the CRA’s administrative commercial rationality standard, as emphasized above, and the wording of subparagraph 247(2)(b)(i).
17 Whether or not the sham doctrine could be successfully invoked by the CRA in these circumstances would depend on whether the parties’ course of conduct corresponded with their contractual arrangements. See footnote 14 in this regard.
18 M.N.R., Information Circular 87-2R, ‘‘International Transfer Pricing’’ (September 27, 1999) at paragraphs 43 and 44.
19 OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax ‘‘Guides’’ Administrations, OECD, 1995, at paragraph 1.36.
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