Canada: Transfer-pricing appeal
25 February 2014
Posted by: Author: Robert McMechan
Author: Robert McMechan
The TCC dismissed an appeal by the taxpayer in McKesson Canada (2013 TCC 404) from transfer-pricing adjustments to its income under paragraphs 247(2)(a) and (c). Those provisions apply when a taxpayer and a non-arm’s-length non-resident enter into a transaction, or a series of transactions, and the contractual terms and conditions differ from those that would have been made between arm’s-length parties. The taxpayer has appealed to the FCA.
McKesson Canada’s ultimate parent, McKesson Corporation, a US public company, has annual revenues in excess of US$100 billion, owns the McKesson group of companies, and is the largest us health-care company. McKesson Canada is the principal Canadian operating company in the McKesson group, and its core business is the wholesale distribution of over-the-counter and prescription pharmaceuticals. In 2002, McKesson Canada had sales of $3 billion and profits of $40 million. Its customers included some of Canada’s largest retail grocers and drugstore chains. Credit facilities available to it through financial institutions amounted to hundreds of millions of dollars.
In 2002 and prior years, McKesson Canada’s own credit department managed its credit and collection policies and practices. Its receivables had about a 30-day payment average, and 99.96 percent of all receivables were collected. This remarkable collection rate was not expected to change, but in 2002 the McKesson group decided that McKesson Canada would sell its receivables to its immediate Luxembourg parent (MIH) under a receivables sale agreement (RSA) at a discount of 2.206 percent from face value. Simultaneously, under a servicing agreement, MIH would pay McKesson Canada to continue managing the receivables in its credit and collections department under its existing practices. Under the RSA, McKesson Canada was obliged to pay MIH’s costs related to the transactions, including the cost of an intercompany transfer-pricing study.
McKesson Canada reported a tax loss for its 2003 taxation year. The CRA adjusted McKesson Canada’s income for the 2003 taxation year, saying that the RSA’s terms and conditions differed from the arm’s-length terms and conditions that would have been transacted between arm’s-length persons. The minister’s key assumption was that if McKesson Canada and MIH were at arm’s length, the discount rate would have been no greater than 1.0127 percent.
Five expert witnesses testified (and others who did not testify entered expert reports into evidence) over the course of a 32-day trial, during which "reams and reams of documentation were entered into evidence.” After an exhaustive review of the evidence, the TCC concluded that the taxpayer had not met the burden of showing that the reassessment was incorrect and that the taxpayer’s evidence had not even raised a prima facie case.
In the TCC’s opinion, the taxpayer was unable to establish that the RSA’s 2.206 percent discount rate was based on arm’s-length terms and conditions. The TCC said, "Overall I can say that never have I seen so much time and effort by [a taxpayer] to put forward such an untenable position so strongly and seriously. This had all the appearances of alchemy in reverse.” The court also concluded that the transaction’s predominant purpose was to reduce McKesson Canada’s tax on its profits: the RSA appeared to be part of a tax-avoidance plan. The TCC said that there is nothing wrong with a taxpayer entering into tax-oriented transactions and tax planning, and making decisions based entirely on tax consequences (subject to GAAR, which was not relevant in this appeal). However, the primary reasons for and predominant purposes of non-arm’s-length transactions form a relevant part of the factual context and are part of the information used in assessing whether an agreement’s terms and conditions are similar to those that arm’s-length parties would have reached.
The appeal’s outcome was heavily fact-dependent, but the decision deals with several points that are relevant for future cases. The court noted that paragraphs 247(2)(a) and (c) do not permit the recharacterization of transactions that are entered into by non-arm’s-length parties or the substitution of a different transaction. The court concluded that paragraph 247(2)(a) is triggered when the actual terms or conditions differ from arm’s-length terms and conditions and that paragraph 247(2)(c) then mandates an adjustment for tax purposes to the quantum or nature of an amount used by the taxpayer in order to reflect what would have occurred in arm’s-length circumstances.
The TCC said in obiter that transfer-pricing recharacterization is permitted under paragraphs 247(2)(b) and (d) if arm’s-length parties would not have entered into the subject transaction even with different terms, conditions, and amounts, and if the transaction’s only bona fide purpose was to obtain a tax benefit. The court also speculated that there may be a point at which the changes required to reflect arm’s-length terms and conditions will effectively result in a recharacterization. Furthermore, some of the transaction’s terms and conditions may be so fundamental that any change to them may effectively result in a recharacterization. However, the assessment did not rely on paragraph 247(2)(b) or (d), and thus it was not necessary to make a finding on either of these points.
The TCC accepted expert evidence that the appropriate transfer-pricing methodology was not one of the four methods named in the OECD transfer-pricing guidelines, but rather an OECD "other” method. The method adopted by the court was to analyze the risks inherent in the terms and conditions of the RSA as structured and without recharacterization or addition. Evaluating the RSA’s elements individually, the court concluded that parties to a notional arm’s-length RSA would agree on a discount range between 0.959 and 1.17 percent, and the arm’s-length discount rate for 2003—the range’s midpoint—appeared to be less than the rate used in the minister’s reassessment.
A second issue in the appeal was whether the CRA’s related part XIII assessment of McKesson Canada was made beyond the five-year limitation period under the Canada-Luxembourg treaty’s article 9. The benefit that McKesson Canada paid to MIH by reason of transferring its receivables to it at an overstated discount rate was deemed to be a dividend to MIH under paragraph 214(3)(a) for which MIH was subject to part XIII non-resident withholding tax. Under subsection 215(1), McKesson Canada would have been liable to withhold and remit MIH’s tax, and the CRA had assessed McKesson Canada under subsection 215(6)—and not MIH—for an amount equal to what would have been the non-resident’s withholding tax liability
The TCC concluded that the assessment under subsection 215(6) did not meet the treaty’s article 9 requirements for the five-year limitation to apply, and thus that the assessment was valid because under paragraph 227(10)(d) it could be made at any time.
This article first appeared on www.ctf.ca.