In late 2013, the Tax Court of Canada released its decision on a transfer pricing matter in the case of McKesson Canada Corporation vs. The Queen (2013 TCC 404). Under appeal was the assessment of Part I and Part XIII tax resulting from a Canada Revenue Agency (CRA) paragraph 247(2)(c) adjustment of the discount rate applied to the face value of several portfolios of McKesson Canada trade accounts receivable sold during its 2003 taxation year to a related corporation resident in Luxembourg. As a result of the Court’s decision, the discount rate that had been reduced from 2.206% by the CRA at the audit stage to 1.013% was found to have an arm’s length value of between 0.959% and 1.17%. McKesson has filed an appeal of the Tax Court decision with the Federal Court of Appeal.
While the greatest share of the Tax Court decision deals with the quantification of various components of the discount rate and the timing of assessment of withholding tax under the Canada-Luxembourg treaty, several more general but useful reminders of good practice can be taken from the decision. These lessons are the focus of this article, and are worth recalling especially at this time of year, when many companies are preparing transfer pricing documentation in advance of the popular June 30 corporate tax return filing due date.
- State and explain assumptions in documentation, support analytical steps with data and other evidence: The Tax Court was left to examine the facts of the case and conduct its own pricing analysis owing to a number of unexplained assumptions that were made in the McKesson pricing analysis. Averaging periods, risk of default, and discount rates were stated but not explained, and adjustments were made using rough ‘buffer’ factors and measurements of variability.
It is reasonable to expect that CRA and a company can disagree on a transfer pricing method selection or pricing calculation, but it is also reasonable to expect that the reasons for disagreement will become discernible. Without stating assumptions used in calculations (a requirement under paragraph 247(4)(a)(vi) of the Act), a company’s position becomes difficult to explain to the CRA on audit without providing significantly more information and analysis. What’s more, a lack of clarity on assumptions makes it difficult for companies and the CRA to whittle down their respective lists of points in dispute, ‘agree to disagree’ on any specific remaining matters in a fully informed manner, and obtain resolution from Appeals Branch, Competent Authority or the Tax Court.
- Adequacy of documentation – contribution to understanding of facts and circumstances of the transaction: Not only did the Tax Court spend considerable time conducting its pricing analysis, it was left with the daunting task of gathering and interpreting evidence of the facts of the transaction in dispute from the “reams and reams of documentation entered into evidence”. A footnote hints at the diminishing “will to live” experienced by the author when reading his own reasons for judgment in such a matter.
The ‘reasonable efforts’ test of section 247(3) pertains only to the determination of whether a company is liable for a transfer pricing penalty. A company must decide how much effort to make (and expense to incur) in producing transfer pricing documentation. At the same time, a company must consider the expected risk and cost of a bad audit outcome and do a sufficiently good job of telling the story of the transaction in its documentation. The business and commercial circumstances in which the transaction was undertaken, the options available to the transacting parties at the time of the commencement of the transaction, and the expected benefit to the transaction participants are all elements of the story of the transaction. These elements help to support both the existence and the terms of the transaction, both from a business standpoint and in comparison with terms and conditions between unrelated parties.
- Transfer pricing methodologies – other methods and double checking: The Tax Court decision used a transfer pricing method that can only be described as “Other” when compared with the options presented in IC 87-2R. “Other” methods are not new in Canada. General Electric Capital Canada Inc. was decided with reference to an “Other” method. The facts of McKesson do not necessarily lend themselves to a double check of the “Other” transfer pricing method, but the profit consequences of the transaction in dispute were quite clear. McKesson’s profit turned to a loss as a result of the receivable sale transaction. One lesson from McKesson may be that a double check (if practical) of the primary transfer pricing method with a secondary method (or other test) is advisable.
- Timing of analysis (pre- or post- transaction): Though this factor was not essential to the CRA’s case, the decision discusses the timing of the determination of the arm’s length discount in relation to the initial sale of accounts receivable and the initiation of the series of monthly A/R sales transactions. It appears that terms were settled and written into the intercompany agreement before the determination of an arm’s length price could be concluded.
Best practice suggests the right time to price related-party transactions is before a transaction takes place. Second-best practice (which is often the only practical option) requires the determination or adjustment of transfer prices before filing a corporate tax return. This way, intercompany agreements, transfer pricing documentation and taxable income can be consistent.
- Relevance of an intercompany agreement: The Tax Court relied extensively on the agreement between the related parties when determining the terms of the transaction and in conducting its pricing analysis. Though not mandatory, in the case of McKesson the presence of an intercompany agreement contributed significantly to the Tax Court’s decision to examine the pricing of the transaction rather than attributing different terms and pricing to the related-party transaction (re-characterization under paragraphs 247(2)(b) and (d) of the Act). Though the Tax Court’s decision acknowledged McKesson’s international tax structure and a tax motivation to the transaction, the agreement was used extensively by the Court to determine the terms and conditions of the transaction in dispute.
An intercompany agreement is on balance a good thing to have in place, especially in the case of a complex transaction. On the other hand, an intercompany agreement is not a good thing to have if its terms and conditions are not followed, or if it is inconsistent with the transfer pricing analysis and documentation.
- Transfer pricing reports as advocacy documents: A charge of “advocacy” was levelled at certain of McKesson’s transfer pricing studies or reports cited in the Tax Court’s decision. The description of transfer pricing studies and reports furnished to McKesson as advocacy documents I believe neglects the role that such documents play in the real world of Canada Revenue Agency transfer pricing audits.
There is certainly an identifiable line between blindly advocating for a client’s transfer pricing position in spite of the facts and arguing objectively and transparently for a well-supported tax position under section 247(1) (compliance with the arm’s length principle with respect to pricing) and 247(3) (compliance with the section 247(4) documentation requirements). It is however well known that Canada is home to some of the world’s most acrimonious transfer pricing audits. Proposed reassessments are often unsupported by law, administrative guidance, facts, or figures. If this is the world we must work in, I think companies can be excused for advocating responsibly for an income tax filing position pertaining to transfer pricing.
Put differently, I think a certain amount of responsible, principled and well-supported advocacy or argument for a particular transfer pricing methodology, transaction characterization, or calculation method can lead only to more clarity in positions and therefore more efficient resolution of audit disputes. Definiteness in transfer pricing positions is a rare bird these days.
- Selection of an advisor or expert: The McKesson decision is not particularly complimentary of the various advisors and experts retained by McKesson. The question of the relative merits of subject matter expertise versus transfer pricing expertise is raised in several parts of the decision.
The Tax Court had to rely on portions of expert testimony and reports, but ultimately found some use for both the subject matter (securitized lending) and transfer pricing (discount pricing) expert input. This suggests that both types of experts are useful, but perhaps also that each has her/his own function. Despite best efforts by each type of expert, it may remain the case that judicious use of more than one expert or advisor is good practice from the standpoint of establishing a well founded position in facts and circumstances, comparability, and application of a well-selected transfer pricing method.
McKesson’s appeal of the Tax Court’s decision to the Federal Court of Appeal may change how seriously companies should take these lessons. In the short-run, companies should take note of a number of the lessons from the McKesson case when deciding on an approach to selecting a transfer pricing method, applying and supporting a transfer pricing method, and documenting transfer prices to meet the requirements of Section 247.
THE NON-ARM’S LENGTH NEWS is provided as a free service to clients and friends of Cadesky and Associates LLP. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing a tax planning arrangement or taking an uncertain tax filing position. Cadesky and Associates LLP cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.