Until June 10, companies could only make an educated guess when asked whether their Canadian transfer pricing documentation would protect against a penalty under paragraph 247(3) of the Income Tax Act. The Tax Court of Canada’s decision against the taxpayer in Marzen Artistic Aluminium Ltd. v The Queen (2014 TCC 194) has diminished this uncertainty.
Marzen was a B.C. window manufacturer that entered the California market, benefiting from the building boom of 2000 and 2001. A change in U.S. marketing strategy sent the company (on the advice of its tax lawyers) to a Canadian lawyer and businessman based in Barbados for further advice. The Tax Court determined the price of this advice (even though it was agreed to have been “game-changing” for the business, and included an annual administration fee for a Barbados subsidiary) was an arm’s length price – $32,500, and used it to uphold CRA’s $7.1M section 247(2)(a) transfer pricing adjustment.
Separate and apart from obtaining the advice, Marzen incorporated a Barbados subsidiary (SII) to perform marketing services in respect of the U.S. market. In exchange for these services, the Barbados subsidiary agreed to receive a fee equal to 25% of U.S. sales. A further 10% bonus was agreed for a time as an incentive to close sales. Marketing functions in the U.S. market were performed by SWI, a Canadian company related to Marzen.
Marzen was selected for an international tax audit in 2003, and responded to CRA’s request for documentation within the three months allowed under paragraph 247(4)(a) the Act. The company submitted the following:
- a cover letter from counsel;
- the four inter-company agreements creating the Barbados Structure
- correspondence between SWI and SII regarding increasing SWI’s fees
- correspondence between SII and Marzen regarding the one-time 10% Bonus Agreement;
- a business study of the U.S. market prepared by a Marzen executive
The Tax Court found that the requirements of subparagraphs 247(4)(a)(v) and (vi) were not met. In short, there were no data, methods, or analyses provided to support the transfer prices used in the related-party transaction and no explanation of the assumptions, strategies or policies that influenced the determination of transaction prices. The Tax Court relied on CRA’s expert rebuttal, written by one of its own economists. A $500,000 penalty was upheld by the Tax Court, even though the income adjustment exceeded the $5M threshold by only $25,000.
Marzen is the type of transfer pricing case that CRA has been waiting to take to trial and win for a number of years. We can expect many others in queue to either settle in favour of CRA on the basis of the Marzen decision or build on the 247(3) jurisprudence if they proceed to trial.
The tax motive for the Barbados structure was noted, but had no influence on the Court’s decision. Extensive questions of substance in the Barbados company were raised at trial, most were decided in favour of CRA, but none was directly crucial to the decision.
This taxpayer, which could have become the first Canadian poster child for the G20/OECD BEPS Project under different circumstances, really lost because it forgot to do the math.
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