REASONS
FOR JUDGMENT
Sheridan J.
I.
Introduction
[1]
These appeals arise out of a transfer pricing
adjustment made by the Minister of National Revenue (the “Minister”)
under paragraphs 247(2)(a) and (c) of the Income Tax Act (the
“Act”) in respect of fees paid by the
Appellant to Starline International Inc. (“SII”), a Barbados-based corporation
wholly owned by the Appellant. In computing its income for 2000 and 2001, the
Appellant deducted the fees paid to SII of CAD$4,168,551 and CAD$7,837,082,
respectively.
[2]
In 2000 and 2001, SII paid to Starline Windows
Inc. (“SWI”), another corporation in the Appellant’s group of companies, a
total of US$1,383,723 and US$1,811,992, respectively, for the secondment of its
employees to perform certain services for SII.
[3]
In 2000 and 2001, SII declared dividends of
CAD$2,011,500 and CAD$5,299,620, respectively. The Appellant included these
amounts in its income for Canadian tax purposes in the 2000, 2001 and 2002
taxation years. The dividends were then deducted from the Appellant’s taxable
income pursuant to section 113 of the Act on the basis that they had
been paid out of SII’s exempt surplus.
[4]
In reassessing the Appellant’s 2000 and 2001
taxation years, the Minister disallowed the deduction of any amounts in excess
of the fees SII paid to SWI:
|
2000
|
2001
|
Paid by the Appellant to SII
|
$4,168,551
|
$7,837,082
|
Paid by SII to SWI
|
($2,058,049)
|
($2,811,892)
|
|
|
|
[5]
A transfer pricing penalty of CAD$502,519 was
levied under subsection 247(3) of the Act for the 2001 taxation year
only.
II.
Witnesses
A. Appellant’s
Lay Witnesses
(1) Mr.
Ron Martini
[6]
During the years in question, Mr. Martini, was
the president and sole director of the Appellant. With only a grade 7
education, Mr. Martini immigrated to Canada at the age of 18. After working for
two years as a welder, he and three partners incorporated the Appellant in
1970. Approximately 20 years later, Mr. Martini and his wife had become the
sole owners of the company and by 1995, the Appellant was the largest window
manufacturer in British Columbia.
[7]
Mr. Martini struck me as a man whose many years of
experience in the industry had made him a knowledgeable and astute businessman.
(2) Mr.
Art Fabian
[8]
Like Mr. Martini, Mr. Fabian also immigrated to Canada and established himself in a successful business career. He earned a Bachelor of
Science in Education in the Philippines where, after graduating, he taught high
school physics. He then became a medical sales representative for
GlaxoSmithKline in Manila, receiving regular promotions until 1989 when he and
his family immigrated to Canada. He immediately began work as a shoe salesman
in Vancouver and by late 1990, had become the company’s area supervisor. He
left that employment to sell windows for a business which soon after, was
purchased by the Appellant. In 1991, Mr. Martini placed Mr. Fabian in charge of
overseeing the company during the transition period. With his background in
science, sales and management, Mr. Fabian soon worked his way up to becoming
what Mr. Martini described at trial as his “right-hand
man” in the Appellant’s business operations.
[9]
Mr. Fabian was the first witness to be called
and spent all of one day and most of the next morning on the stand. He was very
thorough in his explanation of, among other things, the business of selling
windows, the different requirements of the single home residential market and
the high-rise condominium market and especially, the nature of the Appellant’s various
operations. However, he was less forthcoming when it came to explaining the
role played by Mr. Csumrik in respect of the functions of SII and SWI.
(3) Mr.
David Csumrik
[10]
Mr. Csumrik is a lawyer with a background in
accounting and an impressive history in various business dealings in Canada and the US. As of the time of trial, Mr. Csumrik was the principal of Longview Associated
Limited (“Longview”), a company engaged in establishing international business
corporations in Barbados and providing management and administrative support
services to them.
[11]
Mr. Csumrik’s testimony often left me with the
impression that there was more to the story than the Court was hearing. His
overall credibility was further weakened by discrepancies between his sworn
evidence at trial and certain written representations he provided during the
audit in respect of the role he played in the functions of SII and SWI. More
will be said about this later.
B. The Respondent’s Lay Witness
(1) Mr.
Thomas Stasiewski
[12]
The Respondent called Mr. Thomas Stasiewski, a
former employee of the Canada Revenue Agency (“CRA”) who performed all but the
preliminary steps of the audit of the Appellant’s 2000 and 2001 taxation years.
Mr. Stasiewski has a Certified General Accountant designation and began work
with the CRA in 1975. He held various positions in the auditing field
throughout his career; by the time the Appellant’s audit began in 2003, Mr.
Stasiewski was in a section of the International Audit Department that dealt
with transfer pricing issues. I found Mr. Stasiewski to be a credible witness.
[13]
Although initially intended to be the
Respondent’s nominee on examination for discovery, Mr. Stasiewski retired prior
to the conduct of discoveries. He declined to attend on the Respondent’s behalf
because of Treasury Board policies restricting the amount of his remuneration.
As a result, Ms. Tanya Fleck, another CRA auditor became the Respondent’s
nominee on discovery.
[14]
At trial, the Appellant moved to have Mr.
Stasiewski excluded as the Crown’s witness. That motion was dismissed for the
reasons given at pages 793 to 798 of the Transcript.
[15]
For ease of reference, Mr. Stasiewski is referred
to herein as the “Primary Auditor” and Ms. Fleck, as the “Nominee Auditor”.
C. Expert Witnesses
(1) Appellant’s
Expert: Mr. Barry MacDonald
[16]
The Appellant called as its expert witness Mr.
Barry MacDonald, a partner at PricewaterhouseCoopers LLP with some 30 years
experience in transfer pricing and international tax planning. Mr. MacDonald
was duly qualified as an expert witness for the Appellant and his expert report
entered in evidence as Exhibit A-2 (“Appellant’s Expert Report”).
(2) Respondent’s
Expert Witness: Mr. Oliver Rogerson
[17]
The Respondent’s expert witness was Mr. Oliver
Rogerson, the Chief Economist for the CRA based in Ottawa. Mr. Rogerson began
his career with the CRA in 1999 and specializes in transfer pricing analysis.
[18]
After Mr. Rogerson was duly qualified as the
Respondent’s expert witness in the field of economic analysis of transfer
pricing, the Appellant objected to the admissibility of the report he had
prepared. After hearing the submissions of counsel, the report was excluded for
the reasons given at pages 798 to 807 of the Transcript. There was no objection
to Mr. Rogerson’s Rebuttal Expert Report and it was duly admitted in evidence
as Exhibit R-1 (“Respondent’s Rebuttal Expert Report”).
III.
Evidence
A. Background
[19]
The parties filed a Statement of Agreed Facts
and a Joint Book of Documents.
Portions of the examinations for discovery were read in at the hearing.
[20]
At all relevant times, the Appellant was engaged
in the design, manufacture and sales of aluminium and vinyl window products
(“Window Products”) in Langley, British Columbia. The Appellant’s sole director
was Mr. Ron Martini. Mr. Martini and his family controlled directly or
indirectly the Appellant, SII and SWI. Thus, the Appellant, SII and SWI are
deemed under the Act not to deal at arm's length.
[21]
SWI was located in Washington State. SWI was a tax resident of the United States (“US”) where it filed tax returns for the
taxation years 1998 to 2001. Mr. Rick Stark became the general manager of SWI
in April 1998.
[22]
SII, a tax resident of Barbados, was incorporated in Barbados by Mr. David Csumrik, also a resident of Barbados, on September 29, 1998. Mr. Csumrik acted as the company’s initial director and on
February 11, 1999 became its managing director. Two other directors were also
appointed at that time, Mr. Stark and Mr. Terry Vipond, Mr. Martini’s
son-in-law.
[23]
Mr. Csumrik was also the principal of Longview. Neither Mr. Csumrik nor Longview was related to the Appellant, SII or SWI for
the purposes of the Act.
B. Activities
Prior to July 1, 1999
(1)
Appellant’s Direct Sales to US – 1993 to early 1998
[24]
By 1995, the Appellant was the largest window
manufacturer in British Columbia with the majority of its customers in the
Lower Mainland and branches in Kamloops, Kelowna and on Vancouver Island.
Ninety per cent of its sales revenue was attributable to the single-family
residential market, the remaining ten per cent to high-rise buildings.
[25]
While most of its sales were in Canada, from 1993 to early 1998, the Appellant also attempted, with limited success, to sell Window
Products directly from its location in British Columbia to customers in the US residential market.
(2)
SWI’s Sales Activities in US – April 1998 to June 1999
[26]
In 1998, Mr. Martini decided to shift this role
to SWI. SWI had been incorporated in Washington State sometime prior to 1993
and was reinstated as a Washington State corporation on September 21, 1993
where it remained inactive until 1998.
[27]
In April 1998, SWI opened a sales office and
storage facility near Seattle, Washington. Mr. Stark, an experienced general
manager in the Appellant’s Victoria sales office, was transferred to the SWI
office to act as its general manager. Mr. Stark hired and trained a staff of
approximately 20 employees to provide sales, administrative, accounting,
storage and delivery services for SWI. SWI carried its own property and
liability insurance.
[28]
Like the Appellant in Canada, SWI’s focus in Washington State was the residential market. SWI purchased Window Products from the
Appellant at a price which would provide a margin of 15-18%. SWI had access to
the Appellant’s computer system, including its price list. SWI personnel
solicited orders for Window Products from US customers and entered those orders
directly into the Appellant’s system for manufacture at the British Columbia
plant.
[29]
During the 1998 fiscal period, SWI realized
sales revenue of US$551,320 and incurred a loss of US$487,309. Mr. Martini asked
Mr. Fabian to look into the company’s failure to penetrate the Washington State residential market. After discussions with Mr. Stark, Mr. Fabian
determined that SWI was being outflanked by its larger and better-established US competitors.
[30]
Around this time, Mr. Martini and Mr. Fabian
also met with counsel for the Appellant at Thorsteinssons LLP in Vancouver to discuss the utilization of SWI’s losses. During his examination-in-chief Mr.
Martini explained that counsel “…suggested that if I
needed a marketing person he knew of one that could have probably, possibly
help us”.
That person was Mr. David Csumrik.
(3)
Mr. Csumrik and Longview
[31]
At the time of counsel’s discussions with Mr.
Martini and Mr. Fabian, Mr. Csumrik was living in Barbados. In the 15 years
prior to his relocation there in 1997, Mr. Csumrik had been involved in various
businesses in Canada and the US. He invested in and acted as the CEO of a Vancouver company selling specialized lighting systems to theatres in the US. Next, he and a partner established a computer software development and licensing
company. His partner provided the technical know-how and Mr. Csumrik, the business
expertise. That venture ultimately led to the sale of one of the company’s
products to Microsoft Windows for an undisclosed amount, reportedly a
$20-million-dollar transaction.
[32]
After the sale, Mr. Csumrik carried on as a
consultant in Vancouver obtaining software licensing agreements and raising
investment capital for other companies. Looking to invest some of the profits
from the Microsoft deal, Mr. Csumrik then teamed up with two Toronto-based real
estate developers. That endeavour was ultimately unsuccessful and Mr. Csumrik
returned to Vancouver.
[33]
In 1996, he collaborated with his former
high-tech partner to launch a plant biotechnology company. To undertake this
project, certain exploitation rights had to be acquired from the Carnegie
Institution of Washington (“Carnegie”). According to Mr. Csumrik, his partner “… was instrumental in convincing them that we would use more
efforts to exploit the technology than would Monsanto”; Mr. Csumrik’s role was to
conduct negotiations to secure the licensing agreement with Carnegie’s chief
financial person.
[34]
Mr. Csumrik sought advice from Thorsteinssons
LLP as to how to structure the new endeavour in a “tax
efficient manner”.
He and his partner ultimately decided to establish the company in Barbados and in 1997, Mr. Csumrik moved to Barbados where they:
… formed a company called Linnaeus Inc. in
Barbados, licenced it as an international business company in Barbados, set up
the attendant bank accounts, the requisite licensing agreements with Carnegie,
and … did business as Linnaeus and still do business as Linnaeus Inc. from Barbados.[7]
[35]
In the spring of 1998 Mr. Csumrik established Longview, a company which he described as providing “one-stop
accounting, corporate administration, corporate secretarial, office facility;
like a packaged office with, as I say, accounting, clerical, administrative and
corporate secretarial”
for companies incorporated in Barbados. He set up Longview after being
approached by a client referred to him by Thorsteinssons LLP looking to incorporate
in Barbados. This was followed by two other Thorsteinssons LLP referrals and
subsequently, other clients who had heard of Longview by word of mouth.
[36]
On cross-examination, Mr. Csumrik provided
further details of Longview’s services: it provided staff to maintain the books
of account and prepared financial statements of the international business
corporation, kept business registrations current with the Barbados authorities,
prepared Barbados tax returns, provided someone to answer the phone and handle
correspondence, maintained the corporate records required to operate the
company, provided legal referrals in Barbados to set up additional corporations
or trusts, opened bank accounts in Barbados or elsewhere in the world, as
required.
The usual fee for such services was US$30,000 annually.
[37]
For an annual fee of US$2,500, Mr. Csumrik (through Longview) would also provide his personal services as managing director to Longview’s corporate clients. As such, he would perform the following tasks:
A
|
As the manager I
would direct the staff to fulfill all the requirements of -- the daily
requirements of the business, be it taking orders, processing orders, paying
bills, dealing with customer queries. I would then oversee the corporate -- I
would be the general manager of the business as it operated in Barbados, or from Barbados.
|
Q
|
Now, the staff, for
example, or the business activities of the company, would that be something
[the client would] supply to you? Would [the client] provide the staff and
you manage them? Or would Longview provide … the staff as well?
|
A
|
It would be by
circumstance. In certain instances we would -- Longview would supply the
accounting, staff the clerical. In some cases we have supplied customer
support whereby we have -- customers would phone in to get support and they
would phone a person in Barbados. We would supply that. In other instances we would manage the sales people or the technical
support people throughout the world. We would manage them from Barbados. They would report to us although they would get paid either as independent
contractors and/or if they were in the U.S. they would get paid by a
facilitating company that would be a non-arm’s-length company to the group,
not --
|
Q
|
Something like SWI was.
|
A
|
Yes, exactly, yes.
|
(4)
Discussions between the Appellant and Mr. Csumrik; the
Incorporation of SII
[38]
In late summer 1998, Mr. Martini and Mr. Fabian
met with Mr. Csumrik in Vancouver. Mr. Csumrik recounted his successful
business record and experience in management and negotiation in Canada and the US. For their part, Mr. Martini and Mr. Fabian explained the nature of the Appellant’s
business and failure to penetrate the Washington State residential window
market. Over the next few weeks, they gave Mr. Csumrik what he described as a “very condensed course”
on the making of windows, including a visit to the Appellant’s manufacturing
plant. Mr. Csumrik also met with Mr. Stark to learn about SWI’s activities in Washington State.
[39]
Shortly after meeting Mr. Martini and Mr.
Fabian, Mr. Csumrik incorporated SII in Barbados on September 29, 1998 with Mr.
Csumrik acting as its first director. Neither he nor Mr. Martini was concerned
about the possible loss of the approximately $2,000 in incorporation costs
should their discussions not bear fruit. Mr. Csumrik said the company could
always be used for some other client looking to incorporate in Barbados.
[40]
Discussions continued between Mr. Martini and
Mr. Csumrik and it was understood that Mr. Csumrik expected to be compensated
for whatever assistance he might ultimately provide. By the end of 1998, Mr.
Csumrik had concluded that the Appellant was focussed on the wrong market. He
advised Mr. Martini and Mr. Fabian to shift the Appellant’s efforts from Washington State’s residential market to the burgeoning high-rise market in southern California, with a view to targeting western Canadian developers in the area. Mr. Csumrik
admitted that he himself had no contacts with such developers and could not
recall how he had come to know about their projects in southern California:
Q
|
So when you met
with Mr. Fabian and Mr. Martini and then you agreed to assist them and you
undertook the structure, you suggested to them that they should focus on the
high-rise market instead of the residential market. That’s one of the things
you suggested as a marketing strategy, is that correct?
|
A
|
Yes.
|
Q
|
And you suggested
to them that some Canadian developers would be looking to build in the United States and that might give Marzen an in to the U.S. market. Is that also fair?
|
A
|
If I said “in” I
didn’t -- I thought it might help them with a – level the playing field vis-à-vis
competition, yes.
|
Q
|
And you mentioned
specifically to them Bosa and Pinnacle as two developers from Canada that you believed would be taking on projects in the United States.
|
A
|
Yes.
|
Q
|
What was the source
of your belief that Bosa and Pinnacle would be expanding into the U.S.?
|
A
|
I don’t know if I
read it in newspapers, read it in the trade magazines. I don’t even know
where I would have garnered that from, but I somehow came to possess that
knowledge.
|
Q
|
But you weren’t in
contact with people at Bosa or Pinnacle from your days in real estate
development?
|
A
|
No.
|
[41]
As noted at paragraph 11 of these Reasons, this
testimony is at odds with certain written representations made by the Appellant
at the audit stage. These documents were put to the Primary Auditor by counsel
for the Appellant in furtherance of the Appellant’s position that the Primary
Auditor had wrongly rejected the Appellant’s claims regarding the extent of Mr.
Csumrik’s involvement with SII and SWI. In these documents, Mr. Csumrik was
described as having useful contacts with Canadian developers with projects in
the US. The first document was authored by Mr. Csumrik:
Two such developers are the Pinnacle Group
and Bosa Ventures, both of whom were well known to me through my previous
working life as a lawyer/businessman in the Vancouver area. [Emphasis added.]
[42]
The following description appears in a letter
from counsel for the Appellant to the Primary Auditor:
Mr. Csumrik has extensive experience in
managing sales forces in the US for other products. He has key contacts and
personal connections with significant Canadian builders who were entering the
southern California real estate market. It is through Mr. Csumrik’s contacts
that the Company was able to penetrate the California market. [Emphasis
added.]
[43]
Like Mr. Csumrik, the Appellant had had no prior
dealings with such companies but Mr. Csumrik believed the Appellant’s successful
history in the British Columbia residential window business could be leveraged
to its advantage. Mr. Csumrik also testified that he advised Mr. Martini and
Mr. Fabian that because the high-rise market in southern California was
fundamentally different from the residential market in Washington State, SWI’s sales personnel would have to embrace new skills and marketing techniques. Mr. Csumrik’s evidence was that he had learned the importance of
this tactic when dealing with US customers in his theatre lighting business.
[44]
On February 11, 1999, SII’s organizational
resolutions were passed with the Appellant as SII’s sole shareholder. Mr. Stark
and Mr. Vipond joined Mr. Csumrik as directors of the company. Mr. Martini was
aware of Mr. Csumrik’s intention to remain in Barbados and that he expected to
be compensated for his marketing advice. Both parties were interested in
reaching an agreement and discussions continued on how that could be
accomplished.
[45]
Mr. Martini asked Mr. Fabian to summarize what
had emerged from their discussions with Mr. Csumrik over the past few months
and in particular, to identify the possible options. In his Case Study to Mr.
Martini dated April 5, 1999,
Mr. Fabian “highly recommended” the third option,
that the Appellant “acquire the services of a fully
established sales and marketing firm” to market Window Products in the US.
Mr. Fabian prepared a second document dated April 26, 1999 and entitled “A
Study of the Three Major Industry Segment that Will Directly Affect Our
Successful Business Launching and Bolster Market Share in the United States of America”.
[46]
By the early spring 1999, Mr. Martini and Mr.
Csumrik had reached an agreement regarding his compensation. According to their
testimony, they had a “hand-shake” agreement that
if his advice proved successful, Mr. Csumrik, in his personal capacity, would
be remunerated by Mr. Martini and/or the Appellant in some fashion at an
undetermined time in the future. Mr. Csumrik’s evidence was that he was
comfortable with this loose arrangement first, because both he and Mr. Martini
were “old style” businessmen who trusted each
other. He added that this had always been his preferred manner of doing
business.
[47]
In support of his claim of a separate remuneration
arrangement with Mr. Martini and/or the Appellant, Mr. Csumrik referred to letters
dated January 5, 2004
and June 2, 2008,
respectively, in which Mr. Martini had invited him to pursue business
opportunities involving the sale of certain products manufactured by the
Appellant and/or companies under Mr. Martini’s control. I note that their oral
agreement was not reduced to writing until after the audit began on April 16,
2003. Mr. Csumrik admitted that, as of the time of trial, he had not exploited
either of these opportunities, explaining that in 2004, he was too busy with
his own businesses to take on an additional project and was also embroiled in a
matrimonial dispute. As for the 2008 proposal, Mr. Csumrik said that while he
initially found it attractive, the onset of the US financial crisis later in that
year ultimately made it less so. But both he and Mr. Martini testified that it
was still open to Mr. Csumrik to avail himself of these opportunities should he
choose to do so.
[48]
At the same time Mr. Martini and Mr. Csumrik
were discussing how he would be compensated, Mr. Martini was receiving legal
and accounting advice from Thorsteinssons LLP and other professional advisors
on how best to structure the new marketing approach. Mr. Martini was asked on
cross-examination about his understanding of the reasons for establishing SII
in Barbados:
Q
|
And you believe
that that was necessary because Mr. Csumrik was living in Barbados?
|
A
|
No, that was a
structure that the lawyers and accountant came up.
|
Q
|
What did you
understand about the reasons for adopting that structure?
|
A
|
The reason was that Barbados had a lower tax rate than the Canadian tax rate.
|
Q
|
All right, so income that was earned in Barbados would be taxed at a lower rate.
|
A
|
That’s correct.
|
Q
|
And also I suppose
you must have been aware that income earned in Canada that -- income taxed in
Canada to Marzen would be reduced by marketing fees that Marzen paid to a
marketing company. That would be deductible.
|
A
|
Yes.
|
Q
|
And you also
understood that to the extent that business income was earned in Barbados by
Starline International and tax was paid in Barbados, that under the Canadian
tax regime that money could be paid as a -- that after-tax money could be
paid as a dividend to Marzen as the Canadian parent.
|
A
|
That’s correct, yeah.
|
Q
|
And Marzen would
not be taxable on those dividends received in Canada.
|
A
|
Yes.
|
Q
|
I imagine this made
the structure very appealing to you.
|
A
|
The structure was
appealing, but unless we sold something, the structure would be worth
nothing.
|
[49]
Mr. Csumrik was also asked on examination-in-chief
about the decision to locate SII in Barbados; at no point during that exchange
did he confirm that his residency in Barbados had anything to do with Mr.
Martini’s decision to incorporate SII in Barbados. When Mr. Martini was given
the opportunity to provide further details about this decision on
cross-examination, he candidly acknowledged that Mr. Csumrik’s desire to remain
in Barbados had not been a factor:
Q
|
Did you believe that it was necessary to
have a company in Barbados in order for Mr. Csumrik to provide his assistance
to your marketing efforts?
|
A
|
It didn’t have to be in Barbados, no, but he was in Barbados.
|
Q
|
Right. All right.
Did you believe it was necessary to have a marketing company for Mr. Csumrik
to provide his services to your company?
|
A
|
I didn’t believe it was necessary for
them, no.
|
Q
|
But you went along
with the structure that was proposed to you
|
A
|
That’s correct.
|
[50]
Counsel for the Respondent also asked Mr.
Martini about his expectations regarding the dividends that the structure could
generate if the marketing strategy was successful:
Q
|
At the time the
structure was entered, was it your expectation that dividends would be
declared to the extent that cash was available?
|
A
|
My expectation were
there, yes. If I can add to that, the kind of volume that we were achieving,
we had to restructure Canada, we had to spend millions of dollars in
equipment and buildings and the money was needed in this country.
|
Q
|
I’m not disputing
that you had a use for the money. I’m just asking you about your
expectation.
|
A
|
Okay.
|
C. Activities after July 1, 1999
(1)
Agreements and Arrangements under the Barbados Structure as of July 1, 1999
(a) Arrangement between Appellant
and SWI
[51]
On July 1, 1999 the Appellant continued to
supply Window Products to SWI for resale but with a change in their cost to SWI.
Under the Barbados Structure, the Appellant supplied Window Products at a cost
equal to SWI’s sale price to US customers thus resulting in no profit being
recognized by SWI. The Appellant measured its Window Products sales in the US market by reference to its sales to SWI.
(b) The
Four Agreements under the Barbados Structure
[52]
On July 1, 1999, four agreements were executed
putting in place the new structure for marketing the Appellant’s Window
Products in the US (“Barbados Structure”).
(i) Marketing
and Sales Services Agreement – Appellant/SII (“MSSA”)
[53]
The MSSA is the transaction under review. In the
preamble, SII is described as being “in the business of
marketing products such as” the Appellant’s Window Products.
[54]
Under Clause 1.1 of the MSSA, SII agreed to
provide, inter alia, the following services to the Appellant in
jurisdictions other than Canada or the Caribbean, most particularly in the US:
(a)
|
to use its best
efforts to improve the Appellant’s business by marketing Window Products in
the US;
|
(b)
|
to receive offers
to purchase Marzen products from potential purchasers and forward them to the
Appellant;
|
(c)
|
to prepare and
maintain offer or order schedules and daily sales report summaries;
|
(d)
|
to send out in
accordance with the Appellant’s directions, notices to potential purchasers
who have placed orders to confirm approval, rejection or variance of the
order and then send out additional information as directed;
|
(e)
|
to provide follow-up
correspondence to purchasers in respect of specific queries that may be
raised related to a particular sale of Marzen products;
|
(f)
|
to undertake
evaluations and analysis of Marzen sales through SII as directed by Marzen.
|
[55]
Under Clause 3.2, the Appellant also agreed to advance
to SII “such reasonable amounts as may be requested by
SII from time to time” to assist SII with the costs of providing its
services to the Appellant. Mr. Csumrik explained the effect of this clause as
follows:
… the marketing sales agreement provided that
if we needed working capital, they [the Appellant] must provide it. So we
didn’t have any working capital requirements other than very nominal amounts.
[56]
Under Clause 3.1, the Appellant agreed to pay to
SII a monthly fee equal to the greater of US$100,000 or 25% of gross sales
initiated by SII of Window Products.
[57]
On cross-examination, Mr. Martini testified that
he was responsible for determining the fees the Appellant would pay under the MSSA
and explained how he had come up with the 25% formula:
Q
|
And I think you
referred to comparing your Canadian markup and your Starline Windows 1998
markup as factors in deciding that 25 percent was reasonable.
|
A
|
That’s correct.
|
Q
|
Could you take me
through that decision-making process again, please?
|
A
|
The cost of sales
in Canada for Marzen was 14 percent, 14 to 15 percent. Our cost here in Canada. So we are selling in a market where everybody knows we don’t have to go and look
for new customers, repeated customer. I felt that if we go in the new
country and if I have to market to people that don’t know us, 25 percent was
reasonable.
|
Q
|
And where did the
18 percent markup that you were applying within SWI in 1998 enter into that
decision?
|
A
|
The 18 percent, the
18 percent that we ended up as a markup in 1998 was not done beforehand.
That’s the result of us selling to the marketplace, we ended up with an 18
percent markup. So with an 18 percent markup we still lost 430,000 that year.
|
Q
|
I just want to take
a step back to make sure I understand correctly. The 18 percent markup
you’re referring to in SWI in 1998, how was that determined?
|
A
|
We would sell a
window to SWI. They would buy it from us, our cost plus some overhead, and
then they would go out on the market and sell them to whatever money they
could get. So the market decides what the price is. We don’t decide what the
customer pays for it. And they were actually able to achieve at the end of
the day, 18 percent market.
|
Q
|
So there wasn’t a
formula in place to determine what price Marzen would charge to SWI for the
product?
|
A
|
There was a
formula, was cost plus -- I forget, plus some overhead. I forgot what it was
but almost at cost.
|
Q
|
So what you’re
saying is under that structure, SWI could realize an 18 percent markup.
|
A
|
That’s correct.
|
Q
|
And that wasn’t enough to cover its
costs.
|
A
|
It wasn’t, no.
|
[58]
Although Mr. Martini acknowledged the 25%
marketing fee was greater than SWI’s costs under the pre-July 1999 regime, his
evidence was that he believed the Appellant could still make a profit because
of the increased volume of sales. He said he did not use any comparable
businesses in determining the fee formula because he could not identify any but
also admitted he had not sought professional assistance to assist him to that
end. He had not reduced to writing the basis for his decision.
[59]
Mr. Martini was asked on cross-examination
whether SII’s status as a non-arm's length party had influenced the amount of
the fees under the MSSA:
Q
|
In determining that
you were prepared to pay 25 percent as a marketing fee, did the fact that the
company you were paying to was controlled by Marzen influence your decision?
|
A
|
I thought it was a
common sense decision. Does that answer the question?
|
Q
|
I’m not entirely
confident it does. What I’m asking you is, did you, in deciding that 25
percent was a reasonable amount you were prepared to pay, did you take into
account the fact that the company you were paying to was controlled by
Marzen, was your subsidiary and not an unrelated company?
|
A
|
I would probably
have done that with an unrelated company if that was what they presented to
me.
|
Q
|
Now, if you had
paid marketing fees to an unrelated company, you would not have secured the
same beneficial tax results whereby Marzen could deduct the fees, the company
could pay tax in another jurisdiction, and then pay a dividend back to
Marzen.
|
A
|
No, we would not.
|
Q
|
But you would have done it anyway.
|
A
|
I would have done
it because in times like now, they would be losing money, so it’s beneficial
both ways.
|
(ii) MSSA Bonus Payment Agreement
[60]
Pursuant to an exchange of letters between Mr.
Martini and Mr. Csumrik
in August 2000, the MSSA was amended to provide that the Appellant 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 between
August 1, 2000 and December 31, 2001 (“MSSA Bonus Payment”; references herein
to the MSSA after the amendment include the MSSA Bonus Payment).
[61]
Mr. Martini testified that he authorized Mr.
Csumrik’s request for the Appellant to pay SII the MSSA Bonus Payment but did
not know how Mr. Csumrik had arrived at the 10% formula. When Mr. Csumrik was
questioned about this during his examination-in-chief, he provided the
following explanation:
Q
|
And when you set up
the 10 percent bonus amount, what was the rationale for asking for 10
percent? Was there any analysis that you’d undertaken?
|
A
|
No. No. I knew we were
going to have some increased costs. I wanted Starline International Inc.
to increase its level of profitability because I knew I would look better if
that was to happen, and because Marzen owned SII and I wasn’t getting any of
this money anyways, he should have been indifferent.
|
Q
|
Did you ultimately
direct Starline Windows to increase its presence in the California market
after this agreement was acknowledged?
|
A
|
I believe we opened
up a sales office. I can’t remember if it was a result of this or if this
was a result of opening up a sales office in California.
|
Q
|
You’re satisfied there’s some link
though.
|
A
|
I’m satisfied that
that would have been -- there’s some connection between the two.[30][Emphasis
added.]
|
[62]
Mr. Martini testified that he had no reason to
think the 10% amount was unreasonable, especially since he countered Mr.
Csumrik’s request with the condition that a minimum of US$10 million in sales
would be achieved during the period. As it turned out, the total sales greatly
exceeded the required minimum resulting in an MSSA Bonus Payment of US$2,090,422.
[63]
On cross-examination, Mr. Martini was asked what
the amounts under the MSSA and the 10% MSSA Bonus had been paid for:
Q
|
Now, you would
agree with me that to the extent that bonus [the 10% MSSA Bonus Payment]
reflected expenses that SII incurred to pay SWI for extra workers or extra
marketing efforts in California, that that bonus went to fund the marketing. You
agree with that.
|
A
|
Yes.
|
Q
|
And if -- you would
also agree, I think, that if SII spent less than the $2 million that you paid
as a bonus on the cost of SWI, that that amount was received by SII as
income.
|
A
|
Yes.
|
Q
|
And you would also
agree that no part of that $2 million went to benefit Mr. Csumrik.
|
A
|
I agree.
|
Q
|
And in fact
wouldn’t you agree that of all of the fees that Marzen paid to SII in 2000
and 2001, which I think totals close to $12 million Canadian, only the
$32,500 per year went to benefit Mr. Csumrik or Longview?
|
A
|
That’s correct.
|
Q
|
And only the
amounts that SWI invoiced SII for to recover the costs of the sales staff
went to benefit the sales people who were making the sales.
|
A
|
That’s correct.
|
Q
|
So whatever their
compensation was, could be salary, could be bonus, that’s paid for through
the cost recovery from SWI to SII.
|
A
|
That’s correct.
|
Q
|
And then
additionally SII has to pay SWI some fees for administrative services, access
to display models.
|
A
|
Yes.
|
Q
|
Those features. But all the rest of the
money, whatever’s left over in the marketing fee paid to SII, that’s income
of SII.
|
A
|
Yes.
|
Q
|
And it doesn’t
provide any benefit to the people that did the marketing sales work, Mr. Csumrik
or the sales people.
|
A
|
No.[31] [Emphasis added.]
|
(iii) Personnel Secondment Agreement – SII/SWI (“PSA”)
[64]
In the preamble to the PSA, SII is described as
being “in the business of marketing windows and doors
designed and manufactured by [the Appellant] in the United States and
elsewhere”. SWI is described as having “qualified
personnel employed in the sales and marketing of windows and doors to be
marketed by SII”.
[65]
Under Clause 1.1 of the PSA, SWI agreed to “provide
the services of personnel on an exclusive basis (‘the Seconded Personnel’) to
be retained and engaged by SII in the marketing of [the Appellant’s] products
in the US and elsewhere (‘the Services’)”. Under Clause 3.1, SII agreed to pay
SWI a monthly fee to cover SWI’s aggregate costs of the employment of the
Seconded Personnel plus a service fee of 10%.
[66]
Under Clause 1.2, SWI agreed to “ensure that the Seconded Personnel seconded to SII to provide
the Services are competent and duly qualified”; under Clause 2.1, SII
was “solely responsible for the direction, administration and management of the
Seconded Personnel”.
[67]
On cross-examination, Mr. Fabian was asked
whether, under the PSA, SWI was in the business of providing personnel and how
it was determined that SWI be paid an additional 10% over its actual costs:
Q
|
… I said SWI is now carrying on a little
business of providing employees to somebody else for profit.
|
A
|
Well, again, at the
end of the day, sir, I would say, I'm looking at more when you said
“business”, like personal [sic, “personnel”], temporary business. You
know, where you have a temp guy, you need somebody at temp. That's the
business that I'm more looking at when you told me that. But, this one is
just incidental, that these people were hired and being used by SII and
therefore SWI should get some profit out of it. Simple, simple, a simple
business thing I believe.
|
Q
|
Are you saying that
there was some sort of negotiation where SWI demanded to be compensated for
this and SII agreed?
|
A
|
There was no,
nothing like that. Again, it's not really their business to provide, like,
you know, a temporary company, a temp company who provides secretarial or
accounting. It's not really like that. They have an existing client, so
again, you know, probably just to be profitable they have ten percent.
|
(iv) Administrative and Support Services Agreement – SII/SWI (“ASSA”)
[68]
Under the ASSA, SWI agreed to provide certain
secretarial and other administrative support services to SII. SII agreed to pay
to SWI monthly fees, as amended from time to time, of US$23,000 (July 1999 –
June 2000); US$30,000 (July 200-June 2001); and US$35,000 (July 2001- December
2001).
[69]
In the preamble to the ASSA, SWI is described as
being “in the business of providing services related to the marketing and
distribution of products designed and manufactured by [the Appellant]”.
[70]
Under Clause 1.6, SWI was “solely
responsible for the administration and management of its employees including
pay, supervision, discipline and all other matters arising out of the
relationship between SWI and its employees”.
(v) Delivery/Depot/Repair
& Maintenance Services Agreement – Appellant/SWI (“DDRMA”)
[71]
Under the DDRMA, SWI is described as related to
the Appellant and carrying on “the business of storage,
delivery, repair and maintenance, and collection services in relation to the
[Appellant’s] products”.
[72]
Under the DDRMA, SWI agreed to provide certain
services in relation to the delivery, depot, repair and maintenance of Window
Products as well as certain bill collection and enforcement duties. The
Appellant agreed to pay the amounts set out in the Statement of Agreed Facts at
paragraph 22(d). The effect of this agreement was that the Appellant covered
all of SWI’s costs related to these services.
(c) Arrangements
between SII and Mr. Csumrik/Longview
[73]
Under a separate arrangement, Longview provided
SII with Mr. Csumrik’s personal services as managing director of SII for US$2,500
annually. Longview provided its local management and administrative services
for US$30,000 annually. These amounts were in accordance with Longview’s usual
rates for such services.
(2) Services
Performed by SII, SWI and Mr. Csumrik/Longview under the Barbados Structure
[74]
During his examination-in-chief, Mr. Martini
summarized the operation of the new marketing structure as follows:
A
|
The new marketing
structure was Mr. Csumrik, the architect of the marketing system, seconded
the people that work at [SWI]. [SWI] would sell the product in the U.S. and they would buy from [the Appellant], and when [SWI] received the money from the
customer, the same amount would go right through [the Appellant], and then [the
Appellant] would pay a 25 percent fee to [SII] for the sales costs.[36]
|
[75]
Although having described Mr. Csumrik as the “architect” of the new structure, Mr. Martini later
admitted that he had no personal knowledge of what Mr. Csumrik actually did; he
relied on reports from Mr. Fabian and Mr. Stark. Mr. Stark, SWI’s general
manager, was not called as a witness at the hearing.
[76]
Mr. Csumrik that he was in regular contact with
Mr. Fabian:
Q
|
What was the purpose of those
conversations?
|
A
|
The purpose of
those conversations – it should be appreciated that there’s a learning curve
that happens when you get involved in a new business. I wasn’t -- I didn’t
understand the business. Mr. Fabian did understand the business. So we
would talk about, okay, an order goes in, when is it going to ship? You
know, what are the problems? How come those are -- how come something got
returned? How are we going to ship, you know, this big order if $3 million
worth of windows comes in? This wasn’t a carry-on of previous business down
there. This was -- you know, this was expanding their capabilities and it was
all new business so it was a learning process. So we probably spoke weekly if
not more.[38][Emphasis
added.]
|
[77]
Mr. Fabian testified that he was closely
involved with the Appellant’s day-to-day operations. Mr. Fabian provided a detailed
explanation of the complicated process of bidding on, ordering and invoicing
and scheduling the supply of windows to high-rise developers in southern California. What came out of this was that Mr. Fabian was worthy of Mr. Martini’s
description of him as his “right-hand man”. As
shown in the testimony below, he was the overseer of all aspects of the
Appellant’s sales and marketing in the US, including the activities of Mr.
Stark in the US and Mr. Csumrik in Barbados. He testified that he normally
called Mr. Csumrik once a week:
Q
|
And what would you discuss in your weekly
call?
|
A
|
We were discussing
about the new project that they have, also discussing about the updates of
how Mr. Csumrik and his team are doing in terms of implementing the concept
and strategy that we have put in place with this new marketing agreement. And
also there are times that we have discrepancy with the books where, for
example, the sales has to be reconciled with what we have and what they have
and what Starline Windows Inc. has. So we have to practically reconcile and
making sure we are not missing anything or we’re not over charged by Starline
Windows Inc. or Starline International Inc.[39]
|
[78]
However, Mr. Fabian also kept in close contact
with SWI’s general manager, Mr. Stark:
Q
|
And how much interaction did you have
with Mr. Stark?
|
A
|
I have so much
interaction with Mr. Stark too, mainly because Mr. Stark is a non-technical
guy, he is actually a salesman, a good salesman so he would ask me questions
about technical issues about the windows. And I would also ask him how they
are progressing with their target in the high-rise market in the areas that
Mr. Csumrik would have asked them to target, just to get an update. And also
to update me on current coming sales or whatever it is that is on the plan so
that we would know or I would know and I can relay that information to Mr.
Martini at the end of the day.[40]
|
[79]
Mr. Fabian also kept Mr. Martini informed of the
progress being made in southern California. Although described as a “hands-off” employer, Mr. Martini was still keeping an
eye on sales under the Barbados Structure, just as he had done prior to July 1,
1999. Of particular interest to him were the sales results as documented in the
company’s “Red Book”:
Q
|
So is that -- when
you mention the red book, is that the summary that you received?
|
A
|
I received a
monthly summary but it’s -- of course is an addition of all the days, yeah,
yeah.
|
Q
|
So you didn’t get
the weekly report, you got a report that took the weekly results and
accumulated them and it was for each month.
|
A
|
Yes, yeah.
|
Q
|
And what was the
value of that red book to you and the information that was contained on it?
|
A
|
Information was --
that’s how I could tell the performance for the sales team. We always had it
from day one actually. And also it allow us to schedule the
work that was coming up, went to manufacture and what -- and if we had
actually enough room in those days.[41][Emphasis
added.]
|
[80]
It is clear from the above testimony that Mr.
Fabian was the hub of the Appellant’s wheel of operations both before and after
July 1, 1999. As such, he was very familiar with the activities of SWI
personnel during both periods and was asked on cross-examination to compare
their duties, having reference to SII’s sales and marketing obligations to the
Appellant under Clause 1.1 of the MSSA (see paragraph 55, above). After
reviewing each of these items on cross-examination, Mr. Fabian conceded that,
with the exception of sub-clause 1.1(a), prior to July 1, 1999, SWI had
performed essentially the same tasks now ascribed to SII under the MSSA:
Q
|
Now, we’ve just
looked at a list of six things that SII is responsible to do for [the
Appellant] under the marketing and sales services agreement. It seems like
all of that stuff was previously done be SWI employees, is that correct?
|
A
|
What do you mean?
|
Q
|
Well marketing
products, receiving orders, transmitting them, preparing schedules,
summarizing sales, corresponding with purchasers, all that stuff was done by
SWI employees before you set this structure in motion.
|
A
|
By SII?
|
Q
|
Before SII came on
board all of these things were done by SWI.
|
A
|
Yes, they did
actually but our result is minus $487,000. Yes, they did, but they were not
effective in doing the --
|
Q
|
Yes. But let’s
leave the marketing aside. The receiving orders, the reconciling sales
reports, the corresponding with purchasers, all of that was done by SWI.
|
A
|
That's right. …[42]
|
[81]
However, Mr. Fabian went on to say that
sub-clause 1.1(a) was by far the most important of SII’s obligations under the MSSA.
Like Mr. Martini, Mr. Fabian credited Mr. Csumrik, on SII’s behalf, with having
designed and implemented the marketing services:
… [because of the $487,000 loss] we need
somebody to train Mr. Rick Stark to focus on the things that he has to do, and
during the time that this was not in place … Mr. Rick Stark is not achieving
anything. Probably they know that this is part of their job, but nobody's
coaching them on what to do. Nobody is training them, nobody is leading them,
nobody is directing them; nobody is quarterbacking those people. That's why
Mr. Csumrik came to me and start quarterbacking, leading these people,
directing them, telling them, you need to hire people who are technically
inclined, that knows exactly or that they can sit down with the developer and
discuss projects without being like, “What are you talking about?” They also
need to make sure that there is customer service, customer service, follow-up.
All these things have to be done.
So in SWI, prior to 1999, they know that this
is part of -- it's a marketing concept that has to be followed by any marketing
company. However, … Mr. Rick Stark and his group are not doing it the right way.
That's why we need somebody like marketing director like Mr. Csumrik who can
lead this thing so that we can move forward and start earning -- start
profiting in SWI.
[82]
Although counsel for the Respondent invited both
Mr. Fabian to elaborate on what Mr. Csumrik did as “coach”
or “quarterback”, he was unable to do so. Such
vagueness was completely at odds with Mr. Fabian’s other detailed testimony and
his natural willingness to provide full answers whenever he could.
[83]
Similarly, Mr. Csumrik, who had given candid and
detailed descriptions of his prior personal business successes, had little say
about the practicalities of his coaching duties on behalf of SII. Like Mr.
Fabian, he also resorted to generalities in describing his role – indeed, his
evidence only became detailed when explaining what he did not do:
… I wasn't -- I didn't make sales. I'm not a
salesman. I didn't intend to learn all the ins and outs of the windows
themselves. I didn't intend to -- I wasn't earning a finder's fee. That's not
what I was doing. I was just trying to tell [Mr. Stark] how to do business down
there and who I thought he should do business with, and you know, why I thought
that. So I guess I was like a mentor, a coach, a director.
[84]
However, Mr. Csumrik did provide some
specific examples of his activities. Mr. Csumrik said he was concerned that Mr.
Stark would be unable to make the transition from the residential sales
strategy based on “relationships” to the technical
sales requirements of the high-rise market. For that reason, he said, he stayed
in regular contact with Mr. Stark to keep him focused on these objectives. Mr.
Csumrik cited one example of correspondence
where Mr. Stark appeared to be “reverting to his legacy”; that is to say, focussing on
the Washington State residential market. Mr. Csumrik’s reaction was effectively
to ignore such behavior because he “… wasn’t very
interested in the residential sales. I was interested in the high-rises that
were projects that had been recently sold, and asked [Mr. Stark] for a list so
I could review it.”
[85]
Mr. Csumrik also described his role in reviewing
the “Red Book” and gave
examples of occasions where he had identified reporting errors of a clerical
nature affecting SII’s financial obligations to SWI. He said he reviewed bids
and if ever there were problems, discussed them with Mr. Stark. A weakness of his
evidence was there was little documentary evidence to support claims of close involvement
in SWI’s operations. Mr. Csumrik explained that was because he was more
comfortable using the phone or email.
On the rare occasions he reduced such communications to writing, he explained,
the purpose was “… frankly, because I wanted to build a
file for reasons of taxation for the most part. … this was sort of just to show
that there was some business being conducted in Barbados for the most part.”
[86]
As noted above, Mr. Csumrik had no contacts
among the Canadian developers with projects in southern California which
limited his capacity to steer SWI employees to an particular potential client:
Q
|
What was your
involvement in the process of the sales staff going to Bosa and making that
sale, getting that contract?
|
A
|
I didn’t have any
direct involvement in that process.
|
Q
|
Did you tell Mr.
Stark or his project coordinator or sales people or whoever it was what to do
or what to say to Bosa or who to go to?
|
A
|
No.
|
Q
|
And you didn’t talk
to anyone at Bosa and say, you know, “Remember me? I think you should give
these guys a look. They’ve got a good product.” Nothing like that?
|
A
|
No
|
Q
|
So after
recommending that they should target particular developers and particular
projects, you left it to the sales team to go out there and do the legwork
and make it happen.
|
A
|
Yeah, left it to the sales team to do
their jobs, yes.[50]
|
[87]
Mr. Csumrik went on
to explain the level of his involvement in pursuing new projects once the
initial sale had been made, including how he came to know about them:
Q
|
Then after the
Horizon project there were more sales, more sales to Bosa and more sales to
other developers. What was your involvement in securing those contracts?
|
A
|
I wasn’t a
salesman. I had no involvement in securing any contracts.
|
Q
|
Did you direct the
sales team back to more projects?
|
A
|
Yes.
|
Q
|
And how were you
aware of those projects?
|
A
|
Again, if you read
the industry papers and the -- over the internet, which is how I would do it
because I was in Barbados, people talk about it, pending projects, da da da,
Bosa doing a big expansion into San Diego and on and on. So you hear it from
the architects. I didn’t hear it from the architects in San Diego but it
comes back. So you just -- you know. I mean you would know if you were in
the business.
|
Q
|
Was there no one at
Starline Windows Inc. or Marzen who could also follow those developments and
that information?
|
A
|
Well, Mr. Stark
wasn’t. I wasn’t familiar with anybody else whose position it was to make it
their business to do that, but Mr. Stark, that was not his level or his
comfort zone.
|
Q
|
Now, after that
first contract was secured, the Horizon one, what do you know about how the
bid to Bosa for the next project was received? Do you know anything about
that, other than that a contract was secured?
|
A
|
I'm sorry, the
question?
|
Q
|
All right. Well,
it just seems to me that after -- maybe after Starline has done the Horizons
project, Bosa now sort of knows them. When Bosa is going to do the next
project, maybe they’re more receptive to Starline. Would you agree with
that?
|
A
|
You would hope they
would be.
|
Q
|
And that’s the
whole point of the marketing strategy, isn’t it?
|
A
|
Again, you would
hope that you did a good job on the first contract and they would be
comfortable with the pricing and the service and the value they derived from
the first contract. You would hope that that would help you get the second contract,
yes.
|
D. The
Audit; Examination for Discovery “Admissions”; Cross-examination of the Primary
Auditor; and the Primary Auditor’s Penalty Recommendations
(1) The
Audit
[88]
Because the Appellant raised certain issues
regarding the Primary Auditor’s conclusions upon which the reassessments were
based and the approach taken to the imposition of penalties under subsection
247(3), it is useful to set out a brief summary of the relevant aspects of the audit
process.
[89]
The audit began as a domestic audit but was
later assigned to the International Audit Department because of the international
nature of the Appellant’s operations. Notice of the audit was first sent to the
Appellant by Primary Auditor’s predecessor on April 16, 2003. A little over a year later,
the file was reassigned to the Primary Auditor. Although there had been at
least one meeting and some correspondence
between the former auditor and the Appellant, the Primary Auditor said that
when he took over the file, he “started from scratch”.
[90]
In a letter to the Appellant dated June 2, 2004,
the Primary Auditor requested certain documentation from the Appellant. In response to that request,
counsel for the Appellant wrote to the Primary Auditor describing, among other
things, the corporate entities involved and their roles together with that of
Mr. Csumrik and Longview.
The Appellant ultimately delivered several boxes of documentation to the
Primary Auditor which he testified he reviewed before reaching the conclusions
reached in his Functional Analysis,
Audit Report
and Proposal Letter.
(2) Examination
for Discovery of the Nominee Auditor: “Admissions”
[91]
As noted above, although the Primary Auditor
performed the lion’s share of the audit, he was not the Respondent’s nominee in
examination for discovery; that role fell to the Nominee Auditor. In his
opening remarks, counsel for the Appellant indicated to the Court his intention
to show that certain answers given by the Nominee Auditor on discovery amounted
to admissions that some crucial findings made at the audit stage by the Primary
Auditor - particularly those relating to the functions performed by SII, SWI
and/or Mr. Csumrik – were incorrect. In support of these contentions, counsel
for the Appellant read in certain portions of the examination of the Nominee Auditor
which he submitted contradicted the Primary Auditor’s conclusions that:
1.
|
there was “no evidence” of meaningful
services by SII [which corresponds to Assumption 9(kk)];
|
2.
|
marketing of the Appellant’s Starline Window
Products in the US was undertaken “exclusively” by employees of SWI [which
corresponds to Assumption 9(ii)];
|
3.
|
SII provided “no meaningful value-added
services”; and
|
4.
|
the value of Mr. Csumrik’s services was
“zero”.
|
(3)
Cross-Examination of the Primary Auditor
[92]
The Primary Auditor accepted the Nominee
Auditor’s answers as given and admitted they qualified to some extent his
findings as set out above. However, he maintained that the Appellant had still failed
to provide sufficient proof of its claims regarding the role played by Mr. Csumrik,
on behalf of SII, as the designer and director of the marketing operations implemented
by SWI.
[93]
Counsel for the Appellant then took the Primary
Auditor through some of the written representations to determine why the
Primary Auditor insisted on “doggedly maintaining that
the Appellant’s documents were not evidence of anything”. Counsel for
the Appellant put to the Primary Auditor certain of the Appellant’s documents provided
during the audit describing Mr. Csumrik’s role: two documents prepared by counsel
for the Appellant (referred to herein as “Tab 54” and “Tab 57”, respectively) and one by Mr. Csumrik (referred to herein as “Tab 59”) at the audit stage.
[94]
Turning first to counsel’s description of Mr.
Csumrik’s role in Tab 54, that document is a letter from counsel for the
Appellant dated July 9, 2003 in response Primary Auditor’s request for
information when he took over the Appellant’s file in June 2003:
Q
|
And the second last paragraph it says:
“During the course
of our recent meeting you had the opportunity to meet and interview David
Csumrik, who is the managing director of SII. Mr. Csumrik has extensive
experience in managing sales force in the United States for other products. He
has key contacts and personal connections with significant Canadian builders
who are entering the southern California real estate market. It was through
Mr. Csumrik's contacts that the companies were able to penetrate the California market.” [Emphasis added.]
|
|
So you reviewed that and rejected it.
|
A
|
There was no evidence to support it.
|
Q
|
You gave it zero weight.
|
A
|
I considered it, but in short of having
something to support it, what was I going to do?[Emphasis added.]
|
[95]
Counsel for the Appellant also took the Primary
Auditor through each page of Tab 59, the job description drafted by Mr. Csumrik
personally and enclosed in counsel’s letter to the Primary Auditor dated June
16, 2005. Beginning at the bottom of page 1, in pages 2 and 4 of the document
Mr. Csumrik described his duties as managing director of SII.
[96]
On page 3 of Tab 59 Mr.
Csumrik set out what “generally
could be referred to as coordination of the sales and marketing activities and
indirect supervision of the seconded [SWI employees]”. Mr. Csumrik then continued to describe his services as follows:
… Again, as you are aware these services mimic
the services that SII by agreement is obligated to provide to … [the
Appellant]. The sales and marketing functions are provided by the sales and
marketing personnel seconded by SII from [SWI].
The supervision of these personnel is
undertaken in a couple of ways, firstly by being in constant contact with the
General Manager of SWI and secondly by receiving and reviewing the “Red Book
Sales” on a weekly basis. Red Book Sales provides me on a weekly basis with
each person’s orders for that particular month broken down by territory and
providing the amount of the discount from list price. Rick and I would then
discuss and correspond on the specific location and timing of various projects.
[97]
After reviewing this description with the
Primary Auditor, counsel for the Appellant put the following questions to him:
Question
|
So [Mr. Csumrik’s]
given a general description of what he does in the second and third paragraph
with respect to coordinating the sales staff. Do you agree that that's what
he's doing?
|
A
|
That's what he says
he's doing.
|
Question
|
And you don't
accept that that's what was done?
|
A
|
That's the whole
point, I think. We don't accept that. There's no evidence to support it. [Emphasis added.]
|
[98]
Returning, now, to Tab 59 for the conclusion of
Mr. Csumrik’s explanation of his role, he wrote:
From time to time I will direct the
sales/marketing team to projects that I have knowledge are in the works.
You may be aware that a significant amount of our expansion in the US market has come from the California market, initially the San Diego/Carlsbad area and more
recently the San Francisco area. What you may not be aware of is the fact that Vancouver based developers led the way in both of these markets. Two such developers are the
Pinnacle Group and Bosa Ventures, both of whom were well known to me through my
previous working life as a lawyer/businessman in the Vancouver area.
Certainly my previous experience as a lawyer and business person has been
invaluable in my role with the company. My previous real estate development
activities certainly provided me with the experience and expertise to allow
me [sic] understand the business and to assist it in providing
leadership from here in Barbados. [Emphasis added.]
[99]
A similar statement appears in paragraph 2 of
page 3 of Tab 57, counsel’s description of Mr. Csumrik’s role:
… In addition to Mr. Csumrik’s exploiting
his direct relationship with certain Canadian real estate developers
undertaking significant projects in California, Mr. Csumrik was also
responsible for coordinating the selling efforts of the seconded employees of
SII in the United States. … [Emphasis added.]
[100] After having reviewed these various documents and upon being asked
for his reaction to them, Primary Auditor had this to say:
Q
|
And just again,
looking at the description on page 3 of the letter of what Mr. Csumrik does,
second paragraph down, you gave that no weight?
|
A
|
There is no
evidence. I had no evidence to support any of this. This is just a
statement.[Emphasis added.]
|
(4) Primary
Auditor’s Penalty Recommendations
[101] Another issue canvassed by counsel for the Appellant during his
cross-examination of the Primary Auditor was his recommendation to the CRA’s
Transfer Pricing Review Committee regarding the basis for the imposition of a penalty
under paragraph 247(4)(a) of the Act:
Q
|
And I think the
last thing I want to explore is you said in your testimony that if you had
received a response to your proposal letter you might have adjusted it.
|
A
|
Well I would have
-- definitely if you had concerns with the functional analysis we would have
entertained your thoughts on it.
|
Q
|
Now would you agree
with me that the assessing proposal that you set out put the appellant in the
worst possible position? So you’ve simply allowed or you’ve allowed
nothing in relation to the services that are provided to the appellant save
and except for the costs that are incurred by SWI?
|
A
|
Right.
|
Q
|
You’ve given no
value at all for anything else?
|
A
|
Right.
|
Q
|
And you’ve also
been able to impose -- would you agree that the limitation for imposing a
penalty is you have to be in excess of $5 million in adjustments?
|
A
|
Yes, I believe
that’s correct.
|
Q
|
And then for the
2001 year they are just over that threshold, aren’t they?
|
A
|
I believe they were
if I look at this, wherever it is. Yes, they were.
|
Q
|
So if we had -- if
there had been any credit given in relation to the services provided by SII,
they would have been under the $5 million threshold?
|
A
|
If anything had
changed in the audit, they very well could have been. [Emphasis added.]
|
[102] And again, at the end of the cross-examination of Primary Auditor,
counsel verified the Primary Auditor’s conclusions regarding what value ought
to be ascribed to the services the Appellant received under the MSSA:
Q
|
Mr. Stasiewski
having regard to the documents that we’ve gone through today and the
submissions, I suggest to you that in the course of your audit you had ample
clear evidence of the functions performed by the parties including the
involvement of Mr. Csumrik, the nature of their relationships, the amounts
paid by Marzen to SII, the huge increase in the U.S. sales following the
adoption of the new marketing strategy, and the value that was received by
Marzen as a result of the strategy being implemented. Would you agree with
that?
|
A
|
I had a pretty good
idea of what was going on.
|
Q
|
And having
regard to all that you concluded that the value that SII brought, together
with the seconded employees who were performing services on behalf of it, was
no greater than the amounts that were being paid by SII to SWI?
|
A
|
That's correct.[Emphasis added.]
|
E. Financial
Results under the Barbados Structure
[103] It is an agreed fact that Window Products sales increased from
US$551,320 in 1998 to US$4,952,859 in 1999 to US$11,983,554 in 2000 and
US$13,230,737 in 2001. Almost all the sales achieved in 2000 and 2001 were made
to two Canadian developers in southern California, Bosa Brothers and Pinnacle.
[104] In 1999, 2000 and 2001, the Appellant paid SII fees under the MSSA
of US$755,700, US$2,803,326 and US$3,051,668, respectively. In 2001, the
Appellant also paid SII a one-time bonus amount of US$2,090,422 under the MSSA
Bonus Payment. The Canadian dollar amounts for the total fees paid in 2000 and
2001 are CAD$4,168,551 and CAD$7,837,082, respectively.
[105] In 1999, 2000 and 2001, SII paid SWI fees under the PSA and the ASSA
totalling US$606,732, US$1,369,721 and US$1,811,922. The Candian dollar amounts
for the total fees paid in 2000 and 2001 are CAD$2,058,049 and CAD$2,811,892,
respectively.
[106] In addition to its sales revenue, SWI included in its income the
fees received from SII under the secondment and administrative services
agreements (including the employee cost recovery amounts, not just the 10%
markup), and from the Appellant under the delivery/depot agreement.
[107] In its financial statements, SWI deducted the expenditures that were
cost-recovered from SII pursuant to the secondment agreement, and from the Appellant
pursuant to the delivery/depot agreement.
[108] In 1999, 2000 and 2001 SWI’s net profits were US$274,032 in 1999,
US$241,499 in 2000 and US$733,432 in 2001.
[109] In computing income from operations in the 1999 to 2001 taxation
years, the Appellant deducted the marketing fees paid to SII as an expense. In
its income statement, the Appellant included dividends received from SII as “other income” and added to it income from operations in
determining income before taxes. The Appellant’s financial results included the
following, shown in Canadian dollars:
1999 Year
|
|
Revenues
|
$38,876,749
|
Gross margin
|
$9,396,094
|
Income from operations
|
$43,377
|
Other income (no dividend from SII)
|
$24,108
|
Income before taxes
|
$67,485
|
|
|
2000 Year
|
|
Revenues
|
$44,650,187
|
Gross margin
|
$13,557,642
|
Income from operations
|
$450,290
|
Other income (no dividend from SII)
|
$1,988,037
|
Income before taxes
|
$2,438,237
|
|
|
2001 Year
|
|
Revenues
|
$54,440,728
|
Gross margin
|
$17,431,267
|
Income from operations
|
($748,018)
|
Other income (no dividend from SII)
|
$5,560,931
|
Income before taxes
|
$4,812,913
|
[110] In both the 2000 and 2001 taxation years, the marketing fees paid to
SII were the largest expense on the Appellant’s income statements.
[111] Paragraphs 54-56 of the Statement of Agreed Facts show that SII’s
financial results in 1999, 2000, and 2001 included the following (US$):
1999 Year
|
|
|
Revenue
|
|
|
|
Marketing fees
|
$755,701
|
Expenses
|
|
($674,986)
|
|
Net Income
|
$80,715
|
|
|
|
2000 Year
|
|
|
Revenue
|
|
|
|
Marketing fees
|
$2,850,174
|
|
Interest
|
$5,072
|
Expenses
|
|
($1,453,341)
|
|
Net Income
|
$1,401,905
|
|
|
|
2001 Year
|
|
|
Revenue
|
|
|
|
Marketing fees
|
$5,236,186
|
|
Interest
|
$5,309
|
Expenses
|
|
($1,847,106)
|
|
Net Income
|
$3,394,119
|
[112] SII’s pre-tax profits from 1999 to 2001 totalled US$4,876,739
(approximately CAD$7.3 million).
[113] According to its 1999 through 2001 Barbados corporate tax returns,
SII paid total income taxes in Barbados of US$121,985, as follows:
1999
|
$2,086
|
2000
|
$35,047
|
2001
|
$84,952
|
TOTAL
|
$121,985
|
[114] It is an agreed fact that commencing in April 2000, SII began
declaring and paying quarterly dividends to the Appellant as follows, shown in
US dollars:
2000 Year
|
|
|
April 24
|
$75,000
|
|
August 15
|
$675,000
|
|
December 15
|
$600,000
|
|
Total
|
$1,350,000
|
(Cdn $2,011,50)
|
|
|
|
2001 Year
|
|
|
May 31
|
$360,000
|
|
July 26
|
$375,000
|
|
October 22
|
$175,000
|
|
December 31
|
$2,525,956
|
|
Total
|
$3,435,956
|
(Cdn $5,299,620)
|
[115]
Mr. Csumrik explained how these amounts were
determined and paid:
Q
|
Were you given any
instructions with respect to when to declare a dividend, or how much the
dividend should be?
|
A
|
I would advise --
at the end of each quarter, I would advise the shareholder as to how much
cash and retained earnings were available should they want the directors to
declare a dividend. So --
|
Q
|
So would it be then
the shareholders’ decision to have a dividend declared?
|
A
|
Well, in law the
directors do it. But I believe we consulted with the shareholder.
|
Q
|
Now, if we just go
back to the April 2000 dividend, after that is declared, the retained
earnings remaining in the company are about $3,000. By August 15th, 2000,
you don’t know what the financial results for 2000 will be, do you?
|
A
|
No.
|
Q
|
And you don’t know
what retained earnings there will be at the end of 2000.
|
A
|
No.
|
Q
|
But you were able
to pay a dividend of $675,000.
|
A
|
Well, yes, we paid
it, yes.
|
Q
|
And what was that
determination based on?
|
A
|
That was based on
the results for the first quarter ended March 31. Sorry, it is probably for
the first two quarters ended June 30th. We would have had enough cash in the
bank, together with enough retained earnings for current fiscal period,
six-month period earnings to pay 675.
|
Q
|
So if you didn’t
know the retained earnings for that year and there was no retained earnings
from 1999, this would be based on how much cash was on hand and your estimate
of what was actually needed as working capital?
|
A
|
No. It would be
based on the actual earnings for the six-month period ended June 30th, 2000.
It was -- we didn’t have any working capital requirements, in essence,
because the agreement provided if we had any, we’d get the money from
Marzen. I forget which paragraph that was in both the administrative --
sorry, I think it was the secondment agreement. No, sorry, the marketing
sales agreement provided that if we needed working capital, they must provide
it. So we didn’t have any working capital requirements other than very
nominal amounts.
|
IV.
Legislation
[116] The relevant portions of subsection 247(2) of the Act read as
follows:
247(2). 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 series of transactions and
(a) the terms and conditions made or imposed, in respect of the
transaction or series, between any of the participants in the transaction or
series differ from those that would have been made between persons dealing at
arm's length…
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 or fiscal period 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,
(c)… the terms and conditions made or imposed, in respect of the
transaction or series had been those that would have been made between persons
dealing at arm's length…
V. Issues
[117] It is agreed that the Appellant and SII were not dealing with each
other at arm's length under the MSSA. The issues in these appeals are as
follows:
1. whether the terms and conditions imposed in
respect of the MSSA between the Appellant and SII differ from what would have
been agreed to by persons dealing at arm's length;
2. if yes, what adjustments should be made to
the quantum of the fees that the Appellant paid to SII under the MSSA so that
it is equivalent to the price that would have been paid had the Appellant and
SII been dealing at arm's length; in other words, whether the Appellant would
have paid SII any fees under the MSSA in excess of the amounts allowed by the
Minister had they been dealing at arm's length; and
3. whether the Appellant is liable to a penalty
under subsection 247(3) of the Income Tax Act in respect of the transfer
pricing adjustment made for its 2001 taxation year.
[118] Each of these issues will be dealt with separately under the
headings below.
A. Issue 1: Whether the price paid
by the Appellant to SII under the MSSA differs from what would have been paid
had they been dealing at arm's length.
(1) Appellant’s
Position
[119] The Appellant’s position is that having regard to the marketing
structure put in place by the Appellant and SII, the terms and conditions
adopted by the parties regarding the services provided directly and indirectly
by SII do not differ from those that would have been agreed upon between arm's
length parties. The Appellant contends that the Court must take into account both
the direct services provided by SII and also the indirect services rendered by
SWI employees under the secondment agreements between SWI and SII. Indeed, the
Appellant argues that SWI and SII must be treated as one entity referred to as
an “amalgam” whose functions included Mr. Csumrik’s involvement. As will be
discussed below, this factual assumption formed the basis of the Appellant's
Expert Report and informed its approach to the transfer pricing analysis.
[120] According to the Appellant, upon the establishment of the Barbados
Structure on July 1, 1999, SII - under the direction of Mr. Csumrik and in
collaboration with SWI - undertook the marketing of the Appellant’s Window
Products in the US. Mr. Csumrik, on behalf of SII, developed the marketing
strategy used under the Barbados Structure and provided on-going supervision
and advice to SWI in furtherance thereof. Because of these relationships, the
Appellant submits that SII and SWI must be viewed as acting as one entity under
Mr. Csumrik’s direction in the performance of SII’s obligations to the
Appellant under the MSSA.
[121] The Appellant further contends that the “proof is in the pudding”,
noting that under the Barbados Structure, the Appellant achieved an impressive
increase in sales, proof in itself that the payment of the fees under the MSSA
was justified.
[122] The Appellant also argued that the admissions of the Nominee Auditor
on discovery and the Primary Auditor’s testimony at trial dealt a grievous blow
to the assumptions underpinning the Minister’s reassessments. According to
counsel, the combined effect of the Nominee Auditor’s answers on discovery and
the Primary Auditor’s cross-examination showed him to be “incapable
of articulating any basis for rejecting” the Appellant’s position
during the audit that:
1. the Appellant received
service of substantial value under the MSSA;
2. Mr. Csumrik provided on-going
direction to the SWI sales team; and
3. without the direction and
participation of Mr. Csumrik, the Appellant would not have successfully
penetrated the US high-rise market.
[123] In these circumstances, it is the Appellant’s position that a
reasonable business person standing in the shoes of the Appellant and dealing
at arm's length from SII would have paid the fees under the MSSA.
(2) Respondent’s
Position
[124] The Respondent’s position is that there is no evidence to show that
SII provided any meaningful services, or that such services would have
justified, to an arm's length person, the payment of the majority of the fees
under the MSSA.
[125] The Respondent rejects out of hand the Appellant’s treatment of SII
and SWI as a single entity under the Barbados Structure, arguing that the arm's
length principle requires an entity-by-entity approach to a transfer pricing
analysis.
[126] The Respondent also contends that the Appellant has not met its onus
of proving incorrect the assumptions underpinning the reassessments. In
reassessing the Appellant’s 2000 and 2001 taxation years under subsection
247(2) of the Act, the Minister made the following general assumptions
as set out in paragraph 9 of the Reply to the Notice of Appeal:
9(uu)
|
the terms and
conditions made or imposed between the Appellant, SWI and SII with respect to
the Barbados Marketing Structure differed from the terms and conditions that
would have been made or imposed had those parties been dealing at arm's
length;
|
9(vv)
|
an arm's length’s
party would not have paid SII the marketing fees that the Appellant did in
the 2000 and the 2001 taxation years for the services that SII provided;
|
[127] In making an adjustment to the price under the MSSA, the Minister
concluded that only the amount SII paid to SWI under the PSA and the ASSA was
an arm's length amount and made the following further assumptions:
9(ii)
|
marketing of the
Appellant’s products in the United States was undertaken exclusively by the
employees of SWI;
|
9(kk)
|
SII performed no
meaningful value-added services in Barbados to support the Appellant or SWI;
|
9(pp)
|
The profits
allocated to Barbados (marketing fees paid by the Appellant less fees paid to
SWI) were not paid out by SII to cover costs or expenses incurred by SII or
to compensate its managing director David Csumrik;
|
9(ww)
|
in the 2000 and
2001 taxation years, an arm's length’s party would not have paid marketing
fees to SII that exceeded the fees paid by SII to SWI; and
|
[128] However, in response to the Appellant’s argument at trial regarding
the effect of the Nominee Auditor’s “admissions” on discovery, the Respondent acknowledged
that it was Mr. Csumrik who came up with the “game-changing idea” and that he provided some
useful suggestions and strategic advice and reconciled sales reports on a
weekly basis. But counsel for the Respondent submitted that notwithstanding
these small concessions, the evidence did not support the conclusion that Mr.
Csumrik provided much, if anything, by way of meaningful value-added services to
marketing products or generating sales.
[129] Counsel for the Respondent noted that, as of the hearing, Mr.
Csumrik had received no compensation for his efforts beyond the fees SII paid Longview for his management and director services. He had no employment or contractual
relationship with SII or shares or any other interest in the company through
which he could benefit. The Respondent’s position is that it defies common
sense that an experienced businessman and lawyer like Mr. Csumrik would provide
his services on behalf of SII for so little compensation.
[130] The Appellant’s answer to this was that Mr. Csumrik was to be
compensated for his efforts under a separate arrangement between Mr. Csumrik
and the Appellant and/or Mr. Martini.
[131] According to the Respondent’s analysis, that response results in a
double paradox: the more the Appellant emphasizes the unique value of Mr.
Csumrik’s contribution to SII’s performance of its marketing obligations in
justification of the fees paid to SII, the more unreasonable it seems that Mr.
Csumrik would have provided such services for only minimal compensation. If, as
the Appellant alleges, Mr. Csumrik’s real incentive for creating such value for
SII was a separate compensation agreement with the Appellant and/or Mr.
Martini, that only begs the question of what the Appellant paid SII the fees
for.
[132] Counsel for the Respondent submitted that virtually all profits
realized by the controlled group of the Appellant, SWI and SII in the 1999-2001
years were realized by SII as a result of the marketing fees. Counsel noted
that in the 1999, 2000 and 2001 taxation years, the Appellant had minimal
operating profits followed by losses and SWI had flat operating profits; meanwhile,
SII had exponentially growing operating profits.
[133] In 2000 and 2001, the Appellant paid SII approximately CAD$13
million out of which SII paid to SWI CAD$4.9 million fees for the secondment of
its sales and administrative staff. The remaining balance of just over CAD$7
million was paid to SII for the marketing services under the MSSA; all of these
fees were deducted from the Appellant’s Canadian income with all but a portion
being paid back to the Appellant as exempt surplus dividends.
[134] Counsel for the Respondent acknowledged the objection of counsel for
the Appellant that, because the Appellant could not segment its Canadian and US sales, it was not possible to analyze the Appellant’s performance but maintained that
common sense permitted the inference that the MSSA fees were paid simply to
benefit the Appellant itself.
(3) Analysis
(a) Introduction
[135] The first task is to determine what services SII provided to the
Appellant under the MSSA. For the reasons given below, many of the factual assumptions
in the Appellant's Expert Report regarding the nature of Mr. Csumrik’s
involvement in SII’s and SWI’s activities
are unfounded. As will be further discussed under Issue 2, this was one of the
reasons I chose not to rely upon the Appellant's Expert Report.
[136] There is no question that SII on its own could do nothing. I agree
with counsel for the Respondent’s argument that it was an empty shell with no
personnel, no assets and no intangibles or intellectual property. That SWI
provided sales and marketing staff to SII at an arm's length price under the
PSA and ASSA is not in issue. Thus, the key to determining the services
provided by SII is identifying the role played by Mr. Csumrik; specifically, in
what capacity Mr. Csumrik provided what services to whom and to what extent his
efforts can be attributed to the services SII was obliged to provide to the Appellant
under the MSSA.
(b) Mr. Csumrik’s “Game-changing
Idea”
[137] Both Mr. Martini and Mr. Fabian credited Mr. Csumrik with the idea
of shifting the Appellant’s focus from the Washington residential market to
southern California high-rise market; counsel for the Respondent conceded it
was Mr. Csumrik who came up with that “game-changing idea”. Even if this is
true, however, the evidence does not support a finding that
Mr. Csumrik provided that service on behalf of SII.
[138] In my view, Mr. Csumrik developed and provided that advice in his
personal capacity directly to Mr. Martini/the Appellant. First, there is the
question of timing: the testimony of the Appellant’s witnesses showed that by the
fall of 1998 Mr. Csumrik had advised Mr. Martini and Mr. Fabian that the
Appellant should change its market focus and apply different marketing
techniques. While counsel for the Appellant argued that Mr. Csumrik
incorporated SII in expectation of using it to direct the Appellant’s marketing
efforts, the evidence shows that when Mr. Csumrik came up with the new
marketing strategy, SII was languishing on a shelf in Barbados, waiting for
someone – according to Mr. Csumrik’s evidence, possibly the Appellant or perhaps
one of Mr. Csumrik’s Longview clients - to make use of it.
[139] By the time SII became part of the new marketing structure on July
1, 1999, it was because the Appellant had already accepted the marketing advice
Mr. Csumrik had provided directly to Mr. Martini and had decided to target the
southern California high-rise market. There is no evidence that Mr. Csumrik
transferred any proprietary interest he may have had in that idea to SII. On
this latter point, this is one of the flaws in the Appellant's Expert Report which
will be discussed under Issue 2: the Appellant's Expert Report assumed that the
marketing strategy was SII’s “valuable intangible” asset but reached no conclusions as
to whether it had belonged to Mr. Csumrik initially and was transferred to SII
or had been created by Mr. Csumrik on behalf of SII after July 1, 1999.
[140] Finally, there is the matter of Mr. Csumrik’s compensation. It was
the Appellant, not SII, who found Mr. Csumrik and availed itself directly of
his marketing advice. Mr. Martini’s evidence was unequivocal that no part of
the MSSA fees the Appellant paid to SII was intended for or paid to Mr.
Csumrik. It was Mr. Martini, not SII, who agreed to compensate Mr. Csumrik
personally for that advice. In my view, the evidence
supports the conclusion that, assuming Mr. Csumrik was the source of the game-changing
idea, he provided it to the Appellant in his personal capacity and not on
behalf of SII. Thus, there was no need for the
Appellant to pay fees to SII in respect of that advice.
(c) Mr. Csumrik as the Developer
of SII’s Marketing Strategy and Director of SWI’s Marketing Operations
[141] The next strand of the Appellant’s amalgam argument is that Mr.
Csumrik, on behalf of SII, continued to develop the marketing advice he
provided to the Appellant in collaboration with Mr. Stark and provided on-going
supervision of SWI employees to ensure compliance with the new strategy. In my
view, this very much overstates the role Mr. Csumrik actually played.
[142] First, there is little evidence to show, what additional development
would have been required or actually occurred once Mr. Csumrik had identified
for the Appellant the new market focus and sales approach. While statements in Tabs 54, 57 and 59 of Exhibit A-1 made Mr. Csumrik
out to have had personal connections with the Canadian developers who had
projects in the southern California high-rise market, at trial, he said he only
knew ‘of’ them, apparently from as tenuous a connection as having lived in
False Creek during a time when they may have had projects there. More
importantly, he contradicted his earlier statements,
flatly admitting that he had no contacts among the various developers and thus,
could not direct SWI to any particular individuals in the high-rise market. He
also agreed on cross-examination that if the marketing strategy was effective,
there should not be any need to resell the client on SWI’s capacity to deliver
the goods after the first sale had been successfully completed.
[143] As for Mr. Csumrik’s involvement in the practicalities of designing
new sales techniques for the high-rise market, he explained that he had learned
the importance of meeting the technical specifications and building code
requirements when dealing with US customers in his theatre lighting business.
However, it was not readily apparent how such knowledge would be transferable
to the window business.
[144] In argument, counsel for the Appellant cited Mr. Fabian’s detailed
testimony describing what was required to complete a technical sale to
underscore the difference in sales techniques in the residential and high-rise
markets. Mr. Fabian spent a good deal of time explaining this function; he did
so in a thorough and convincing manner. What I learned from his evidence was
that only someone with considerable expertise and experience in the window
business could devise and manage what counsel himself described as “a
complicated process”.
I did not understand Mr. Csumrik to say that he possessed such attributes; nor
did he explain what he could have contributed to its development beyond his initial
suggestion that SWI adjust its skills to meet the needs of its clients in the
new market.
[145] Regarding Mr. Csumrik’s supervision of the SWI employees, while all
described him as the “coach”, none provided a satisfactory explanation of what
that actually entailed. Mr. Csumrik was candid that
what he knew about the window business he had learned from the “condensed course” provided by
Messrs. Martini, Fabian and Stark. He frankly admitted he was not a salesman
and had no interest in becoming one.
[146] By contrast, Mr. Martini and Mr. Fabian had worked their way up in
the window business. Mr. Martini described Mr. Fabian as his right-hand man;
Mr. Fabian described Mr. Stark as a good salesman with many years
in the business. Although Mr. Stark did not testify, the evidence shows that Mr.
Martini had enough confidence in him to move Mr. Stark from his position of
General Manager on Vancouver Island to head up SWI’s first Washington-based
initiative in April 1998; even after that endeavour produced disappointing
results, he kept Mr. Stark in the position upon the implementation of the
Barbados Structure and at all times during the taxation years under review.
[147] Given such evidence, it is doubtful that once advised of the new
market focus and the need for a different sales approach, Mr. Stark and the
experienced SWI employees would have to be repeatedly told by Mr. Csumrik – an
admitted neophyte to the business - to pursue Canadian developers and to make
sure they met their product specifications. It is more likely that under Mr.
Stark’s direction, they adapted their residential sales skills and experience
to meet the needs of those with projects in the southern California high-rise
market.
[148] Subject to the concessions of the Respondent as discussed further
under the heading below, I do not accept the Appellant’s contention that Mr.
Csumrik played a significant role on behalf of SII in the development of a
marketing strategy or the on-going supervision of SWI’s activities.
(d) Mr. Csumrik as Manager of
SII’s Marketing Activities
[149] The Appellant further contended that Mr. Csumrik was actively
engaged on behalf of SII in the daily activities of its marketing obligations
under the MSSA.
[150] What evidence is there of Mr. Csumrik’s day-to-day involvement? For
his part, Mr. Martini frankly admitted he had no personal knowledge of Mr.
Csumrik’s regular duties in Barbados, relying on Mr. Fabian for such
information. Mr. Fabian testified he was in regular contact with Mr. Csumrik
after July 1, 1999 and that SWI’s “Red Book” sales reports were duly dispatched to
Barbados for Mr. Csumrik’s review before being sent on to the Appellant. His
testimony was confirmed by Mr. Csumrik.
[151] I am not at all convinced that Mr. Csumrik did much more than give
such records cursory review. But even if I were to accept the fact of such
actions having been taken, there is no evidence of their business utility. Mr.
Martini’s testimony was that the Appellant had “always” used the “Red Book” system to monitor sales and schedule the
manufacturing such orders entailed. After July 1, 1999,
Mr. Fabian continued to review the Red Book, so did Mr. Stark – even Mr.
Martini kept an eye on it. The only difference after the establishment of the
Barbados Structure was that Mr. Csumrik had to go through the same information
before sending it on to the Appellant. Overall, I am persuaded by the argument
of counsel for the Respondent that the purpose in redirecting the flow of
information through Barbados was to make it appear that SII was providing a
valuable service to the Appellant under the MSSA. Indeed, as will be seen from
Mr. Csumrik’s testimony below, maintaining appearances seemed to have been one
of his main concerns.
[152]
Some of the activities that the Appellant
attributed to Mr. Csumrik’s performance of SII’s obligations under the MSSA overlapped
with the various management services he was providing to SII through Longview. For example, Mr. Csumrik noted that he had occasionally came across incongruities
in the sales figures and clerical errors that would have wrongly increased the
amount of fees SII paid to SWI under the PSA and/or the ASSA. This sort of
oversight is not inconsistent with his description of the services Longview typically provided to its off-shore clients. Similarly,
Mr. Csumrik said Longview could manage its clients’ sales
people all over the world from Barbados: “They would report to us although … if
they were in the U.S. they would get paid by a facilitating company that would
be a non-arm’s-length company to the group…” and
acknowledged that was “like” what was done for SWI.
[153] Mr. Csumrik also
commented that his main interest in maintaining records of his communications
with Mr. Stark was “to build a file for reasons of
taxation”. He elaborated on that somewhat ambiguous statement by saying
it was also “just to show there was some business being
conducted in Barbados”. Taken at its most anodyne, this description of
his activities could reasonably be considered part of the corporate management
services Longview was able to provide.
[154] Mr. Martini first became aware of the possibility of enlisting Mr.
Csumrik’s assistance in the context of having sought legal advice in respect of
SWI’s losses in 1998. In his Case Study, which was prepared around the same
time, Mr. Fabian recommended that the Appellant engage “an established sales
and marketing firm”. The evidence shows that Mr. Csumrik did not meet that
criterion but Mr. Martini volunteered that he was willing to put his trust in
Mr. Csumrik on the strength of Thorsteinssons’ recommendation. For his part,
Mr. Csumrik had a history with counsel for the Appellant and obtained advice
from Thorsteinssons in establishing Longview; its first client was a referral
from that law firm. Mr. Csumrik had expertise and experience with international business corporations in Barbados and was able to
provide through Longview “one-stop-shopping” services to its clients.
[155] While Mr. Csumrik was thus well placed to
facilitate the establishment of an international
business corporation in Barbados, his unwillingness to relocate to Canada or the US did not necessitate SII’s establishment in that country. At no
point in Mr. Csumrik’s testimony did he say that was why SII had been
established in Barbados; on cross-examination, Mr. Martini expressly rejected
that contention. Nor was there any obvious need for Mr. Csumrik to provide his services
through a corporation located in Barbados; Mr. Martini agreed Mr. Csumrik could
have provided them directly to the Appellant or SWI. There is no evidence to
support the Appellant’s contention that the Barbados Structure “… was predicated
on gaining Mr. Csumrik’s participation”.
[156] In reaching the above conclusions, I recognize that the Appellant is
entitled to organize its commercial operations in a tax effective manner. I am
not suggesting that Mr. Csumrik was engaged in providing tax advice to the
Appellant.
[157] All in all, I am not persuaded by the Appellant’s argument regarding
the extent to Mr. Csumrik’s involvement in the performance of functions on
behalf of SII. The most that can be said, given the Respondent’s concessions in
respect of the admissions on discovery, is that in fulfilling his duties as
managing director under the arrangement between SII and Longview, Mr. Csumrik
also reviewed some sales records and provided some strategic advice and suggestions
to SWI on behalf of SII.
(e) “The Proof is in the Pudding”
[158]
Finally, the Appellant contended that
proof of Mr. Csumrik’s meaningful involvement in the operations of SII and SWI
and by consequence, of the justification of the MSSA fees, was shown by the
increased sales ultimately achieved in the southern California high-rise
market. This was another key factual assumption
underpinning the approach taken by Mr. MacDonald in the Appellant's Expert
Report, referred to by both Mr. MacDonald and counsel for the Appellant as “the proof is in the pudding”.
[159] Surely, counsel argued, the enormous increase in US sales achieved between July 1, 1999 and December 31, 2001 – in excess of 2,000% - ought to be
proof enough that the Appellant received value for money under the MSSA through
the combined efforts of Mr. Csumrik, SWI and SII. This same proposition was put
to the Primary Auditor on cross-examination:
Q
|
And so we have a new marketing plan and
we've gone from [US$]500,000 or [US$]570,000 to [US$11.2 million] and
[US$12.2 million] in 2000 and 2001. Is that evidence of something?
|
A
|
That just means they got into the market
at the right time and they -- and they actually got in right when the market
was starting to boom in the United States.
|
Q
|
So it was serendipitous? It was just
timing?
|
A
|
I'm just saying there was a number of
explanations that are possible.
|
[160] Notwithstanding counsel for the Appellant’s incredulous reaction to
the Primary Auditor’s testimony, Mr. Csumrik had already made much the same
point in response to counsel’s questions during his examination-in-chief. When
Mr. Csumrik was asked about the sales ultimately achieved by the Appellant in
the southern California market, he described the results as “outstanding” but volunteered the
following reason for that success:
Q
|
And just to close
off, Mr. Csumrik, can you describe the overall results that were achieved
under the new marketing structure that was implemented?
|
A
|
I’d say over a
relatively short term being 2000 to 2005 or ‘7 or whatever it was, that they
were outstanding results. You know, then the real estate market as -- I
would suggest to you that the real estate market was growing, reminded me of
-- somewhat of the software market when I was in that. You didn’t have to be
good, you just had to be there. I mean there were -- things were going.
So we gained market share. I don’t know if we gained it at the expense of
others or if we just gained it because the market was growing in San Diego, Southern California generally in those days, and it was good. It was a fun
ride.[Emphasis added.]
|
[161] Thus, it is clear from the Appellant’s own evidence that the
increase in sales might have been just good timing. While I agree with counsel
for the Appellant that the financial results achieved under the Barbados
Structure are relevant to the arm's length transfer pricing analysis, they do
not, in themselves, justify the fees paid under the MSSA and the MSSA Bonus
Payment Agreement. Another weakness of the “proof is in the pudding” argument
is that it overlooks other aspects of the financial flow in 2000 and 2001; for
example, that under the Barbados Structure the fees paid to SII accounted for the
Appellant’s largest expense, by far; meanwhile, at the same time the Appellant
was reporting losses from its operations, SII’s profits were generating healthy
dividends for the Appellant.
[162] Describing this as a “fantastic state of affairs”, counsel for the Respondent
also noted Mr. Csumrik’s evidence that because Clause 3.2 of the MSSA required
the Appellant to provide, upon request, additional funds to SII for carrying
out its services and because SII had no need for working capital, he was
satisfied that any surplus cash could be paid out as dividends quarterly. Thus,
SII was risk free; just as before the Barbados Structure, the risk remained in Canada with the Appellant.
[163] Counsel for the Appellant rebutted the Respondent’s contention by
arguing that the Appellant was able to pay the dividends because of Clause 3.2.
Counsel for the Appellant also pointed to Mr. Martini’s evidence that the
dividends were used to expand the Appellant’s Canadian business operations to
meet the demands of increased sales in southern California high-rise market.
[164] These arguments do little to advance the Appellant’s case. That the
Appellant put the dividends to good use hardly justifies its payment of fees to
SII under the MSSA. As for the Appellant’s obligation to provide funding under
Clause 3.2 - on demand and in excess of the fees already imposed under the MSSA
– the Appellant’s argument does not address how that would be palatable to an
arm's length party who lacked the Appellant’s capacity to recoup such funds
through dividend payments.
[165] The Appellant’s argument in support of the 10% MSSA Bonus Payment is
equally unconvincing. Counsel for the Appellant sought to justify the formula
first by arguing that Mr. Csumrik had played an active role in its negotiation.
In support of this contention, counsel referred the Court to an exchange of
correspondence between Mr. Csumrik and Mr. Martini. For his part, Mr. Martini
did not know how Mr. Csumrik had come up with the 10% amount; when Mr. Csumrik
was asked about it, he candidly stated:
I wanted [SII] to increase its level of
profitability because I knew it would look better if that was to happen, and
because [the Appellant] owned SII and I wasn’t getting any of this money
anyways, he should have been indifferent.
[Emphasis added.]
[166] Counsel for the Respondent referred to this statement as a “damning” admission that the quantum of
fees the Appellant was paying to SII under the MSSA bore no relation to the
value of services it was receiving. The fees were not paid for anyone’s
benefit; they were just going into SII and back out to the Appellant.
[167] Counsel for the Appellant rebutted the Respondent’s interpretation
of Mr. Csumrik’s statement by arguing that the logical inference to be drawn
from it was that Mr. Csumrik wanted SII to look good because if “… SII looks
good, it’s a result of Mr. Csumrik’s direction and operation and it enhances
his position with respect to future opportunities”.
[168] First of all, in response to the Appellant’s argument regarding the
10% MSSA Bonus Payment, taken in light of all the other evidence, there is
little in the correspondence
cited above to indicate any serious negotiation of a price for services. Mr.
Csumrik could not exactly recall the need for such additional funding and
admitted there was no particular rationale underpinning the 10% amount. But more importantly,
counsel’s characterization of Mr. Csumrik’s statement does not advance the
Appellant’s overall position: taken to its logical conclusion, it reinforces
the fact that Mr. Csumrik was to be personally compensated for his services. I
agree with the contention of counsel for the Respondent that his efforts had nothing
to do with the performance of SII’s obligations that would justify the payment
of fees under the MSSA.
[169] All of which leads back to the double paradox identified by counsel
for the Respondent. Mr. Csumrik had no relationship with SII, contractual or
otherwise, that would have entitled him to any portion of the MSSA fees or the MSSA
Bonus Payment. These fees were not paid with the intention of benefiting Mr.
Csumrik personally; hence, the need for the separate compensation arrangement
with Mr. Martini.
[170] The arm's length principle assumes that independent enterprises “…
will compare the transaction to other options realistically available to them,
and they will only enter into the transaction if they see no alternative that
is clearly more attractive”.
[171] Counsel for the Appellant urged the Court to use common sense in the
assessment of the evidence. Mr. Csumrik and Mr. Martini were experienced and
successful in their respective business endeavours. If Mr. Csumrik, on behalf
of SII, was really performing the crucial marketing services attributed to him
under the Appellant’s argument, why would he have done so for nothing more than
a managing director’s annual stipend? Common sense dictates that he would not
have. Accepting the Appellant’s contention, then, that Mr. Csumrik was to be
paid personally for his efforts under the side deal with Mr. Martini/the
Appellant, it defies common sense that Mr. Martini would also have bound the Appellant
to pay SII for the same services under the MSSA.
[172] I am persuaded by the argument of counsel for the Respondent that
the only inference to be drawn is that the Appellant paid the fees to SII to
secure a tax benefit. The only reasonable explanation for the Appellant to have
agreed to pay SII under the MSSA was so the fees could be reported as profits
and then returned to the Appellant as exempt surplus dividends. Meanwhile, the
marketing fees could be deducted from income for Canadian tax purposes. None of
these attractive advantages would have been available to an arm's length party.
[173] In all the circumstances, the Appellant has failed to demolish the
Minister’s assumptions that:
9(uu)
|
the terms and conditions made or imposed
between the Appellant, SWI and SII with respect to the Barbados Marketing
Structure differed from the terms and conditions that would have been made or
imposed had those parties been dealing at arm's length;
|
9(vv)
|
an arm's length’s party would not have
paid SII the marketing fees that the Appellant did in the 2000 and the 2001
taxation years for the services that SII provided;
|
[174] Accordingly, I find that the terms and conditions of the MSSA
differed from what would have been agreed upon had the Appellant and SII been
dealing at arm's length and that an arm's length would not have paid the
marketing fees that the Appellant did in the 2000 and the 2001 taxation years
for the services that SII provided.
B. Issue 2: Whether the Appellant
would have paid SII any fees under the MSSA in excess of the amounts allowed by
the Minister had they been dealing at arm's length
(1) Introduction
[175] Having answered Issue 1 in the affirmative, it remains to determine what adjustments should be made to the quantum of the fees that the
Appellant paid to SII under the MSSA so that it is equivalent to the price that
would have been paid had the Appellant and SII been dealing at arm's length.
[176] Both parties relied on the principles established in Canada v.
GlaxoSmithKline, 2012 SCC 52 (S.C.C.); The Queen v. General Electric
Capital of Canada, 2010 FCA 344 (FCA); and Alberta Printed Circuits Ltd.
v. The Queen, 2011 TCC 232 (T.C.C.) and directed the Court’s attention to
the OECD Guidelines 1995 and the Canada Revenue Agency’s IC 87-2R.
[177] Because the Act is silent as to how to carry out the analysis
contemplated by subsection 247(2), Canadian courts have endorsed the use of the
OECD Guidelines. The OECD Guidelines do not have the force of law
but rather, are intended as tools to assist in determining what a reasonable
business person would have paid if the parties to a transaction had been
dealing with each other at arm's length.
[178] In GlaxoSmithKline, the Supreme Court of Canada confirmed
that the transfer pricing analysis is strongly fact driven; when assessing the
evidence, the trial judge must keep in mind “the respective roles and functions [of the parties to the transfer
pricing transaction]”. Further guidance may be found in General Electric (F.C.A.)
wherein Noel, J.A. sets out the proper approach to the application of
paragraphs 247(2)(a) and (c):
[54] The concept underlying subsection 69(2)
and paragraphs 247(2)(a) and (c) is simple. The task in any given
case is to ascertain the price that would have been paid in the same
circumstances if the parties had been dealing at arm’s length. This involves
taking into account all the circumstances which bear on the price whether they
arise from the relationship or otherwise.
[55] This interpretation flows from the normal
use of the words as well as the statutory objective which is to prevent the
avoidance of tax resulting from price distortions which can arise in the
context of non arm’s length relationships by reason of the community of
interest shared by related parties. The elimination of these distortions by
reference to objective benchmarks is all that is required to achieve the
statutory objective. … all the factors which an arm’s length person in the same
circumstances as the respondent would consider relevant should be taken into
account.
(2) Expert
Reports
[179] The critical first step in a transfer pricing analysis is to
identify the transaction under review. Because of the significant divergence in
the approach taken by the parties’ expert witnesses in addressing this issue,
it is useful to consider their reports before going further with the analysis
of the evidence.
[180] The Appellant's Expert Report was based on the assumption that SWI
and SII operated as an “amalgam” under Mr. Csumrik’s direction. This approach
was, no doubt, influenced by the manner in which the letter of instruction framed
the questions for his response:
A. In your opinion, what are the appropriate data and economic factors
to be considered when determining what an arm's length person, standing in the
shoes of [the Appellant], would have agreed to pay for the services described
below [in the Factual Assumptions provided to Mr. MacDonald, provided to [the
Appellant] by [SWI] and [SII]? and
B. Having regard to the data identified under A, what is your opinion
as to a reasonable range of prices that an arm's length person, standing in the
shoes of [the Appellant], would have agreed to pay for the services, as such
are described below [in the Factual Assumptions provided to Mr. MacDonald],
provided to [the Appellant] by [SWI] and [SII]? [Emphasis added.]
[181] Mr. MacDonald said he had treated SII and SWI as one entity, referred
to at times as an amalgam, with Mr. Csumrik being somehow rolled up in its
functions, based on the assumptions underpinning the Appellant's Expert Report and his interviews of Mr.
Csumrik, Mr. Martini and Mr. Fabian. On cross-examination Mr. MacDonald
summarized his approach to the functions of each participant under the Barbados
Structure as follows:
Q
|
For purposes of
your opinion, though, I’m going to suggest to you that it doesn’t really
matter who, among those players that I mentioned, Mr. Csumrik, Mr. Stark, the
sales employees and so on, which of those parties performed the tasks that
generated sales. Would you agree with that?
|
A
|
I think I agree
with that. I was looking at the overall marketing structure of the amalgam,
and that was looked at also with the financial results of the amalgam in 2000
and 2001.
|
Q
|
Right. So when you
are looking at the two entities, SII and SWI as an amalgam, you’re basically
looking at them as one service provider to Marzen, to the appellant. Do you
agree with that?
|
A
|
Correct.
|
Q
|
So it doesn’t
matter which of those two entities or who of their employees are working the
phones or presenting to developers or reading the trade journals or looking
at building permits, or any of the things that they might have done?
|
A
|
Correct.
|
[182] Mr. MacDonald acknowledged on cross-examination that the amalgam
approach was contrary to the arm's length principle of treating the members of
an MNE as separate entities. He further acknowledged that the Appellant, SWI
and SII were separate legal entities; that there were contracts in place
between the Appellant and SII, SWI and SII; and the Appellant and SWI; and that
those contracts assigned different functions to the parties. However, he concluded it was
appropriate to bundle SII and SWI together under the MSSA:
A Because stepping in the shoes of whet
[sic] an arm's length parties would do in a situation between Marzen and
SII and the amalgam, I believe that it is important to look at the amalgam
based on the marketing intangibles it has, based on the secondment agreement
and based on the fact that SWI does not earn a gross margin on the re-sale of
its inventory. It earns no profit on that. So this led me to believe that the
two are acting in concert as a marketing service provider and should be
remunerated on its overhead distribution functions -- sales functions I should
say. So those facts led me to my conclusion.
[183] The Respondent’s expert witness, Mr. Rogerson, did not accept the amalgam
approach taken in the Appellant's Expert Report. Although the report Mr.
Rogerson prepared was excluded from evidence,
the Respondent's Rebuttal Report
was admitted and Mr. Rogerson provided the Court with a careful and through
analysis of the weaknesses he had identified in Appellant's Expert Report.
[184] Overall, I am persuaded by Mr. Rogerson’s testimony that the Appellant's
Expert Report was fundamentally flawed in that it wrongly identified the
transaction under review as being between the Appellant and the SWI/SII
amalgam; to treat SWI and SII as one entity was contrary to paragraph of 1.16
the OECD Guidelines 1995 which states that “…the arm's length principle
follows the approach of treating the members of an MNE group as operating as
separate entities rather than as inseparable parts of a single unified
business”.
[185] The amalgam approach is also inconsistent with the evidence of the
Appellant’s own witnesses which shows that they themselves recognized and
understood the individual status and functions of the entities established
under or involved in the Barbados Structure. Turning first to Mr. Martini, when
he was asked on cross-examination who benefited from the fees paid under the MSSA
and the MSSA Bonus Payment, he made a frank distinction between Mr. Csumrik,
SWI and SII in asserting that only SII was the intended beneficiary of such fees.
Similarly, when Mr. Fabian was cross-examined about the terms of the
relationship clauses in the Four Agreements, he exhibited a clear understanding
of the parties’ respective powers:
Q
|
I mean, the reality is, all these
companies [the Appellant, SWI and SII] are controlled by Mr. Martini and his
family, right/
|
A
|
Well, no, it's --
|
Q
|
It's on the schematic. [Schedule A to the
Statement of Agreed Facts]. They can make these -- they can make SWI and SII
agree to whatever they want them to.
|
A
|
No, actually, sir, you know, SWI is a
separate corporate entity that has its own identity, so [Mr. Stark] can
declare and do what he can. So if he change the price of his window and say,
"Mr. Rick Stark said I want to sell my window at 10 percent less",
he has -- he can do that. He's on -- he is his own business. Although it’s
owned by the Martini family, it's still a business on its own that can make
decision for its own.
|
Q
|
Okay. I'm just going to ask you about
paragraph 4.1 of the personnel secondment agreement. So I'll give you a
minute to read it.
|
A
|
Okay.
|
…
|
|
A
|
So Mr. Fabian, this paragraph says:
|
|
"Nothing in this agreement is to be
construed as creating a partnership or joint venture relationship, either
generally or for any specific purpose, between SWI and SII or a former
employee or master/servant relationship between SII and the employees of
SWI."
|
|
So the paragraph says no partnership or
joint venture between SII and SWI, and no employment relationship between the
SWI workers and SII. Are you with me on that?
|
A
|
Yes, sir.
|
Q
|
Why was it necessary to include that
disclaimer in this agreement, do you know?
|
A
|
Because they're not partners to one
another. Starline Windows Inc. is a separate company on its own. SII is a
company on its own. There's no partnership. Starline Windows Inc. is not
part owner to SII, nor SII is part owner or part shareholder of SWI. So
that's what it is.
|
[186] On cross-examination, Mr. MacDonald was asked about paragraph 1.36
of the OECD Guidelines 1995 which deals with the need to respect legal
relationships put in place by the taxpayer:
Q
|
I'm just going to
ask you to go back to those guidelines from the OECD and to turn ahead to
paragraph 1.36… [which] … says in part:
|
|
“A tax administration's examination of a
controlled transaction ordinarily should be based on the transaction actually
undertaken by the associated enterprises as it has been structured by them,
using the methods applied by the taxpayer insofar as these are consistent
with the methods described in Chapters 1, 2 and 3. In other than exceptional
cases, the tax administration should not disregard the actual transactions or
substitute other transactions for them.”
|
|
Now, would you
agree that that guideline says to a tax administration, you need to respect
the legal relationships put in place by the taxpayer?
|
A
|
That's my reading,
yes.
|
Q
|
And would you agree
with the suggestion that a taxpayer pricing its own transfer prices should do
the same thing? The flip side should apply.
|
A
|
1.36 does refer to
exceptional cases, so it's not a rule that applies in every situation, but I
think -- again, going back to accepted transfer pricing practices, it -- we
can look at a bundle of transactions and the economic rights and the
functional circumstances around that and, you know, one party may be
providing things on different terms. So we tend to look at the entirety of
the arrangement when it makes sense, when there's a number of elements
involved. This is not uncommon.
|
Q
|
So the statements
in this guideline, they don’t change your view about the correctness of
viewing SII and SWI for purposes of your transfer pricing study as one?
|
A
|
Well, it could
apply. I won’t dismiss it. I would say that that would be one approach to
look at the transactions under review. I took a different approach which I
feel is also reasonable.
|
[187] On redirect, counsel for the Appellant referred Mr. MacDonald to
paragraphs 1.42 and 1.43 of the OECD Guidelines 1995 and asked Mr.
MacDonald to address questions put to him on cross-examination regarding the
obligation to conduct an entity-by-entity analysis:
Q
|
And I think the
tenor of the questions was to suggest to you that the OECD guidelines want
you to treat entity by entity.
|
A
|
Yes.
|
Q
|
And you indicated
in these circumstances you didn’t believe that was appropriate. I wondered
if you could turn to Section 1.42.
|
|
And if you just
want to take a look at 1.42, and perhaps 1.43.
|
…
|
|
A
|
Yes, I used the
term “bundling” in my reply and they used the term “packaged deal” in 1.43,
so it’s the same effect.
|
Q
|
So these
guidelines, would you agree with me, expressly acknowledge that there are
circumstances when you should combine entities and treat them as an amalgam?
|
A
|
I agree.
|
[188] Counsel for the Appellant relied on this exchange in support of his
argument that the Guidelines did not require an entity-by-entity
approach in every case. However, a review of paragraphs 1.42 and 1.43, the
passages referred to above, shows that they are not talking about entities.
Rather, they deal with the circumstances under which it is appropriate to bundle
transactions between associated enterprises, rather than using the
transaction-by-transaction normally employed under the arm’s length principle.
Similarly, the “package deal” Mr. MacDonald referred to in paragraph 1.43 has
to do combining transactions. There is nothing in paragraphs 1.42 or 1.43 to
suggest it is appropriate to bundle entities under an arm's length analysis.
[189] In rebuttal argument, counsel for the Appellant also suggested that
the reference in paragraph 1.16 to treating associated enterprises as separate
entities must be read in light of the “Global Formulary Apportionment” approach
set out under “Other Methods” in Chapter 3 of the Guidelines. The Global
Formulary Apportionment approach is an alternative to the arm's length
principle. Paragraph 3.61 of the Guidelines states that the advocates of
the Global Formulary Apportionment approach prefer it because, inter alia,:
… an MNE group must be considered on a
group-wide or consolidated basis to reflect the business realities of the
relationships among the associated enterprises in the group. They assert that
the separate accounting method is inappropriate for highly integrated groups
because it is difficult to determine what contribution each associated
enterprise makes to the overall profit of the MNE group.
[190] According to counsel for the Appellant, paragraph 1.16 does not
require that in performing a functional analysis SWI and SII be treated as
separate entities. Rather, the use of the terms “enterprises” and “entities”
throughout the OECD Guidelines 1995 is intentional and reflects the
economic perspective of associated enterprises whose economic functions are
linked rather than the legal perspective urged by the Respondent. Thus, it was
permissible for the Appellant's Expert Report to treat SWI and SII as an
amalgam.
[191] I am not persuaded by this argument either. The chapter dealing with
the Global Formulary Apportionment approach shows that OECD Member countries
have rejected its use in transfer pricing,
in part, because it abandons the separate entity approach. While acknowledging that it
is not always easy to separate the functions of each entity, the Guidelines nevertheless
endorse its application.
[192] Mr. Rogerson identified another flaw in the Appellant's Expert
Report: although premised on the amalgam model, the Appellant's Expert Report
does not consistently adhere to it; from time to time, SWI and SII are also
described as performing separate functions: i.e., SII acting through Mr.
Csumrik is portrayed as the “architect” of the marketing strategy and SWI,
under his direction, as its “executor”.
[193] Finally, counsel for the Respondent submitted that many of the
assumptions underpinning the conclusions in the Appellant's Expert Report – in
particular, those pertaining to Mr. Csumrik’s role - were factually incorrect.
I agree with this contention; as noted in paragraph 135, above, some of the
important discrepancies between Mr. MacDonald’s factual assumptions and my
findings were identified in the consideration of the evidence under Issue 1.
[194] To conclude, having heard the evidence of Mr. MacDonald and Mr.
Rogerson and carefully reviewed the Appellant's Expert Report and the
Respondent's Rebuttal Report in light thereof, I am of the view that the
Appellant's Expert Report should not be relied upon because it is based on
questions that do not properly identify the transaction under review,
assumptions found not to be facts and an approach that is at odds with the
arm's length principle as contemplated by the OECD Guidelines 1995.
(3) Analysis
[195] The critical first step in a transfer pricing analysis is to
identify the transaction under review; in the present case, that is the MSSA (as
amended to include the 10% MSSA Bonus Payment) between the Appellant and SII. The
arm's length principle requires an entity-by-entity assessment of the roles and
functions of those implicated in the Barbados Structure.
(a) The Minister’s Assumptions
[196] It is useful to begin by restating the Minister’s assumptions
regarding the arm's length price:
9(ii)
|
marketing of the
Appellant’s products in the United States was undertaken exclusively by the
employees of SWI;
|
9(kk)
|
SII performed no
meaningful value-added services in Barbados to support the Appellant or SWI;
|
9(pp)
|
the profits
allocated to Barbados (marketing fees paid by the Appellant less fees paid to
SWI) were not paid out by SII to cover costs or expenses incurred by SII or
to compensate its managing director David Csumrik;
|
9(ww)
|
in the 2000 and
2001 taxation years, an arm's length’s party would not have paid marketing
fees to SII that exceeded the fees paid by SII to SWI;
(referred to
collectively as the “Minister’s Price Assumptions”)
|
[197] As noted above in Issue 1, the Appellant contended that the Primary
Auditor wrongly rejected the Appellant’s position that:
1. the Appellant received service of
substantial value under the MSSA;
2. Mr. Csumrik provided on-going
direction to the SWI sales team; and
3. without
the direction and participation of Mr. Csumrik, the Appellant would not have
successfully penetrated the US high-rise market. (referred to collectively as
the “Appellant’s Contentions”)
[198] The Appellant has not fully proven the Appellant’s Contentions. Starting
with point (3) of the Appellant’s Contentions, it may be that, absent Mr.
Csumrik’s idea to change its market focus, the Appellant would not have
penetrated the US market – but the Appellant has not persuaded me that Mr.
Csumrik’s conceptualization and development of the marketing strategy can be
attributed to SII. As for point (1), if by “substantial value” the Appellant
means that the entire amount of the fees under the MSSA were justified, the evidence
does not support such a claim.
[199] However, the Appellant has succeeded, to a limited extent, in
rebutting, in part, the assumptions set out above. As there is a certain
overlap between some aspects of the Appellant’s Contentions and the Minister’
Assumptions, they will be dealt with together. In respect of point (2) of the
Appellant’s Contentions, that Mr. Csumrik provided on-going direction to the
SWI sales team, the Respondent conceded that, contrary to the assumption in
paragraph 9(ii), 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. Thus,
contrary to paragraph 9(kk), he performed, on behalf of SII, some
value-added services in Barbados to support the Appellant or SWI.
[200] However, the performance of most of such services overlapped with the
functions he performed in his capacity as managing director of SII through Longview. From this it follows that the Appellant has successfully rebutted paragraph
9(pp) - but only to the extent that the profits allocated to Barbados
(marketing fees paid by the Appellant less fees paid to SWI) were paid out by
SII to compensate Mr. Csumrik in his role of managing director with
administrative support from Longview.
[201] That leaves for consideration the assumption in paragraph 9(ww) that
an arm's length’s party would not have paid marketing fees to SII that exceeded
the fees paid by SII to SWI. Given the above finding, that assumption has been
rebutted but again, only to the extent that the fees paid by the Appellant to
SII were used to pay for the services provided under SII’s arrangement with Mr.
Csumrik/Longview.
(b) Determination of the Arm's
Length Price
[202] In reassessing the Appellant’s 2000 and 2001 taxation years and
adjusting the price under the MSSA, the Minister did not take into account the
value of the services provided by SII to the Appellant under the arrangement
with Mr. Csumrik through Longview.
[203] According to the Respondent’s position at trial, counsel for the
Respondent submitted that the transaction between the Appellant and SII ought
to be viewed as follows:
• SII contracted to supply services to the
Appellant [under the MSSA];
• SII then sourced those services from SWI
and Mr. Csumrik/Longview under separate subcontracts (the secondment and
administrative agreements with SWI, and retaining Longview);
• SII used the fees paid by the Appellant pay
fees to SWI its secondment fees, and to pay Mr. Csumrik/Longview their fees;
and
• the marketing fees [the Appellant] paid to
SII had three components:
1. a price relating to the re-supply of SWI’s
services;
2. a price relating to the re-supply of Mr. Csumrik’s
services; and
3. a mark-up to SII for co-ordinating such services.
[204] Given that the Minister assumed the fees SII paid to SWI under the
PSA and the ASSA represented arm's length amounts, the Respondent submitted
that the issue boiled down to:
… whether the component of the fees relating to
the re-supply of services of Csumrik; and any amount that functions as a
mark-up to which SII is entitled is an arm's length amount.
[205] Having found that SII performed no functions on behalf of the
Appellant under the MSSA other than those provided on its behalf by SWI and Mr.
Csumrik/Longview, it follows there was no basis for the payment of the mark-up
component to SII.
[206] The Respondent’s analysis is based on the OECD Guidelines 1995 which
provide commentary and methodology for determining whether transfer prices are
consistent with what parties dealing at arm's length would have paid. Paragraph
1.6 of the Guidelines summarizes the application of the arm's length
principle as follows:
By seeking to adjust profits by reference to the
conditions which would have obtained between independent enterprises in
comparable transactions and comparable circumstances (i.e., comparable
uncontrolled transactions), the arm's length principle follows the approach of
treating the members of an MNE [Multinational Enterprise] as operating as
separate entities rather than as inseparable parts of a single unified
business. Because the separate entity approach treats the members of an MNE
group as if they were independent entities, attention is focussed on the nature
of the transactions between those members and on whether the conditions thereof
differ from the conditions that would be obtained in comparable uncontrolled
transactions. Such an analysis of the controlled and uncontrolled transactions,
which is referred to as a “comparability analysis”, is at the heart of the
application of the arm's length principle.
[207] In GlaxoSmithKline Inc., the Supreme Court of Canada
recognized that the exercise of determining an arm's length price is
essentially a comparative one. The difficulty, of course, is to find a proxy
that most nearly replicates the circumstances of the transaction under review.
[208] While the current version, OECD Guidelines 2010, does not
impose hierarchy on the various transfer pricing methods, under the version
applicable to the taxation years under appeal, the OECD Guidelines 1995,
they were categorized in two groups and ranked in descending order of
reliability as follows:
1. Traditional Transaction Methods:
•
Comparable Uncontrolled Price method (“CUP
Method”) Respondent [108] and [160] – value of Mr. Csumrik and Longview
•
Resale Price method
•
Cost Plus method
2. Transactional Profit Methods:
•
Profit Split method
•
Transactional Net Margin method (“TNMM”)
[209] The parties’ experts reached very different conclusions as to which
of these methods was the most appropriate in determining an arm's length price
under the MSSA. Having already declined to rely on the Appellant's Expert
Report for the reasons set out above, it is not necessary to deal at length
with the Appellant’s argument regarding the appropriate methodology to apply in
the present matter. However, I note for the record that the Appellant’s expert
witness concluded that the Transactional Net Margin Method (“TNMM”) would
generate the most reliable result. The TNMM assesses the arm's length character
of transfer prices in a controlled transaction by testing the net profit
results of one of the participants in the transaction against comparable third
party enterprises.
[210] Based on the Respondent's Rebuttal Report prepared by Mr. Rogerson,
counsel for the Respondent argued that the CUP Method ought to be applied in
the present appeals. The CUP Method compares the price paid for a service in a
non-arm's length transaction to the price of a comparable service in an arm's
length transaction. Under the CUP Method, either an internal or external
comparable may be used. An internal comparable compares the transaction under
review to another transaction between one of the parties to the controlled
transaction and a third party.
[211] Counsel for the Respondent contended that the arm's length
transaction between SII and Mr. Csumrik/Longview is a comparable uncontrolled
transaction which could reliably serve as an internal comparable under the CUP
Method. Mr. Csumrik dealt with SII at arm's length; he expected to be
compensated for his work, negotiated a fee and provided his services
accordingly. That fee, US$32,500 fee in each of 2000 and 2001, is a comparable
uncontrolled price (“CUP”) for the controlled transaction between the Appellant
and SII.
[212] Although admitting on cross-examination that the CUP Method was the
method of choice under the OECD Guidelines 1995, Mr. MacDonald rejected
its use in the Appellant's Expert Report because he concluded no reliable
comparable could be identified. He was also of the view that the arrangement
between SII and Mr. Csumrik/Longview was not a reliable CUP Method because it
did not take into account Mr. Csumrik’s compensation under the separate
arrangement with Mr. Martini/the Appellant which, according to Mr. MacDonald
could not be valued.
[213] This is of little assistance to the Appellant. First of all, it must
be noted that the only reason no value could be put on Mr. Csumrik’s side deal
with Mr. Martini/the Appellant was that after some 15 years, he had still not
taken advantage of whatever opportunities that arrangement was supposed to
produce. But in any case, the value of the separate compensation arrangement is
not relevant to the application of the internal CUP as submitted by the Respondent
because that was between Mr. Csumrik personally and Mr. Martini/the Appellant.
It had nothing to do with the provision of Mr. Csumrik’s managing director
services to SII through Longview. Such confusion is the result of the blurring
of roles flowing from the amalgam approach and non-factual assumptions
underpinning the Appellant's Expert Report.
[214] By contrast, Mr. Rogerson’s Respondent's Rebuttal Report, like his
testimony, was thorough and clear in its analysis of the Appellant's Expert
Report. In addition to the other weaknesses he identified in the Appellant's
Expert Report, I also accept Mr. Rogerson’s analysis of the errors and
inconsistencies in the application of the TNMM in the Appellant's Expert Report
and his opinion that they rendered it unreliable. As I have already decided not
to rely on the Appellant's Expert Report, there is no need to set these out in
detail but I hereby adopt the arguments in respect of the Appellant's Expert
Report methodology in subparagraphs 157(dd) to (kk) of the Respondent’s Written
Argument.
[215] I am persuaded by the Respondent’s argument that the arrangement between
SII and Mr. Csumrik/Longview serves as a reliable internal CUP. It accords with
OECD Guidelines 1995 in that it treats SWI and SII as separate entities
and respects the legal relationships created under the Barbados Structure.
Further, it recognizes SII for what it was, “a flow-through entity or
facilitator that makes the services of others available to the Appellant”. I am also satisfied that a
reasonable business person would not have paid SII more than the price Mr.
Csumrik attached to his own services through Longview. It is an agreed fact
that the value of Mr. Csumrik/Longview services was US$32,500 in each of 2000
and 2001.
[216]
Thus, the appeals of the 2000 and 2001
taxation years are allowed, in part, and the reassessments are referred back to
the Minister for reconsideration and reassessment on the basis that an arm’s length’s party would have paid an
amount to SII that exceeded the fees paid by SII to SWI, but only in the amount
of US$32,500 in each of 2000 and 2001.
C. Issue 3 – Penalties
[217] The Minister imposed penalties under subsection 247(3) of the Act
in respect of the 2001 taxation year only. The relevant portions of subsection
247(3) read as follows:
247(3) A taxpayer (other than a taxpayer all of
whose taxable income for the year is exempt from tax under Part I) is liable to
a penalty for a taxation year equal to 10% of the amount determined under
paragraph (a) in respect of the taxpayer for the year, where
(a) the
amount, if any, by which
(i) the total of
(A)
the taxpayer’s transfer pricing capital adjustment for the year, and
(B)
the taxpayer’s transfer pricing income adjustment for the year
exceeds the total of
(ii)
the total of all amounts each of which is the portion of the taxpayer’s
transfer pricing capital adjustment or transfer pricing income adjustment for
the year that can reasonably be considered to relate to a particular
transaction, where
(A)
the transaction is a qualifying cost contribution arrangement in which the
taxpayer or a partnership of which the taxpayer is a member is a participant,
or
(B)
in any other case, the taxpayer or a partnership of which the taxpayer is a
member made reasonable efforts to determine arm’s length transfer prices or
arm’s length allocations in respect of the transaction, and to use those prices
or allocations for the purposes of this Act, and
(iii)
the total of all amounts, each of which is the portion of the taxpayer’s
transfer pricing capital setoff adjustment or transfer pricing income setoff
adjustment for the year that can reasonably be considered to relate to a
particular transaction, where
(A)
the transaction is a qualifying cost contribution arrangement in which the
taxpayer or a partnership of which the taxpayer is a member is a participant,
or
(B)
in any other case, the taxpayer or a partnership of which the taxpayer is a
member made reasonable efforts to determine arm’s length transfer prices or
arm’s length allocations in respect of the transaction, and to use those prices
or allocations for the purposes of this Act,
is greater than
(b) the lesser
of
(i)
10% of the amount that would be the taxpayer’s gross revenue for the year if
this Act were read without reference to subsection (2), subsections 69(1) and
(1.2) and section 245, and
(ii) $5,000,000.
[218] Under subsection 247(3), the penalty is equal to 10% of the amount
by which the transfer price adjustment exceeds the lesser of (a) the taxpayer’s
gross revenues for the year, and (b) $5 million. Thus, no penalty will apply
unless this monetary threshold has been crossed.
[219] In the present matter, in imposing a penalty in the 2001 taxation
year, the Minister relied on the following calculations:
Table 1
|
Amount subject to
Penalty
|
|
|
Table 2
|
Subsection 247(2)
|
Subsection 247(3)
|
Total Sales
|
Adjustment as a
percentage of sales
|
|
Transfer Pricing Adjustment
|
Lesser of 10% of Revenue and $5,000,000
|
Excess
|
Penalty Consideration
|
|
|
Taxation
year end
|
A
|
B
|
C=A-B
|
D
|
D multiplied by 10%
|
|
|
31/12/00
|
$2,110,502
|
$4,465,019
|
Nil
|
Nil
|
Nil
|
$44,650,187
|
4.7%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
[220] In the present matter, if after reconsideration and reassessment of
the 2001 taxation year the transfer pricing adjustment does not exceed the
required threshold, no penalty shall be imposed under subsection 247(3).
[221] In the event that that proves not to be the case, it is necessary to
consider the second aspect of the penalty provision; under clause B of
subparagraph 247(3)(a)(ii) and clause B of subparagraph 247(3)(a)(iii),
no penalty will apply to a transfer pricing adjustment that relates to a
transaction where the taxpayer has made “reasonable
efforts” to determine and use arm's length
transfer prices for the purposes of the Act.
[222] However, these provisions must be read in conjunction with the
deeming provisions contained in subsection 247(4). Subsection 247(4) requires
the taxpayer to make or obtain records or documents supporting the transfer
price in issue by the date that the taxpayer’s return for the year is due and
permits the Minister to request such documentation from the taxpayer. If the
taxpayer fails to provide such information within 90 days of the Minister’s
request, subsection 247(4) deems the taxpayer not to have made “reasonable efforts” to determine and use arm's length
allocations in respect of a transaction.
[223] Paragraph 247(4)(a) further requires that the records or
documentation provide “a description that is complete and
accurate in all material respects” of the items set out in subparagraphs
(i) to (vi); as the provision is written conjunctively, the taxpayer must
fulfill all of these requirements to avoid the effect of the deeming provision:
(i) the property or services to which the
transaction relates,
(ii)
the terms and conditions of the transaction and their relationship, if any, to
the terms and conditions of each other transaction entered into between the
participants in the transaction,
(iii)
the identity of the participants in the transaction and their relationship to
each other at the time the transaction was entered into,
(iv)
the functions performed, the property used or contributed and the risks
assumed, in respect of the transaction, by the participants in the transaction,
(v)
the data and methods considered and the analysis performed to determine the
transfer prices or the allocations of profits or losses or contributions to
costs, as the case may be, in respect of the transaction, and
(vi)
the assumptions, strategies and policies, if any, that influenced the
determination of the transfer prices or the allocations of profits or losses or
contributions to costs, as the case may be, in respect of the transaction;
[224] There are two transfer price amounts under the MSSA that require
consideration under these provisions: the fees under the 25% formula and the
10% MSSA Bonus Payment.
[225] The issue in the present matter is whether the records or
documentation provided by the Appellant in accordance with the Minister’s
request under subsection 247(4)(c) meet the requirements of
subparagraphs 247(4)(a)(v) and (vi), above. There is no dispute that the
Minister sent a written request for contemporaneous documentation on April 16,
2003
and that the Appellant responded by letter dated July 9, 2003(“Appellant’s July 9, 2003
Response”, discussed earlier in these Reasons at paragraph 94). The Appellant
did not take issue with the Respondent’s summary of the contents of the
Appellant's July 9, 2003 Response:
a. a cover letter from counsel;
b.
the four inter-company agreements creating the Barbados Structure (the MSSA,
the PSA; the ASA and the DDRMA);
c. correspondence
between SWI and SII regarding increasing SWI’s fees under the ASA;
d. correspondence
between SII and the Appellant regarding the one-time 10% MSSA Bonus Agreement;
and
e. the business study prepared by Mr. Fabian.
[226] The Respondent’s position is that none of the material in the
Appellant's July 9, 2003 Response addresses the requirements of subparagraphs
247(4)(a)(v) and (vi):
(v)
the data and methods considered and the analysis performed to determine the
transfer prices or the allocations of profits or losses or contributions to
costs, as the case may be, in respect of the transaction, and
(vi)
the assumptions, strategies and policies, if any, that influenced the
determination of the transfer prices or the allocations of profits or losses or
contributions to costs, as the case may be, in respect of the transaction;
[227] According to the Respondent’s argument, the only document that even
touches on these matters is the “Case Study” dated
April 5, 1999
prepared at Mr. Martini’s request by Mr. Fabian regarding how to improve SWI’s
sales in the US. Counsel for the Respondent submitted that while the Case Study
takes a 25% marketing fee as a given in the proposed scenarios, it does not
address how that figure was determined. Counsel noted further that the evidence
of Mr. Martini and Mr. Fabian was that, at the time the Case Study was
prepared, no decision had yet been made as to the amount of the marketing fee.
Mr. Martini said he had come up with the 25% formula based on his own business
experience and observations of SWI’s performance in the US market prior to the implementation of the Barbados Structure. He candidly acknowledged
that he had no documents to show how he had decided on the 25% marketing. He
said he could not find any comparators but admitted that he had not sought
professional advice to assist with that exercise.
[228] Counsel for the Respondent made a similar argument in respect of the
determination of the 10% formula used in the MSSA Bonus Payment. While the
exchange of correspondence between Mr. Csumrik and Mr. Martini shows that amount was
requested and that Mr. Martini agreed to it subject to certain sales levels
being met, it does not explain how the 10% amount was determined. Mr. Csumrik’s
testimony was that there was no underlying rationale for that figure.
[229] In view of the above, the Respondent contends that the Appellant has
failed to meet the requirements of subparagraphs 247(4)(a)(v) and (vi)
is deemed not to have made reasonable efforts to determine and use arm’s length
transfer prices and accordingly, is liable to a penalty in respect of the 2001
taxation year under subsection 247(3).
[230] The Appellant addressed the issue of penalties only briefly in oral
argument. The submission of counsel for the Appellant in response to the
Respondent’s position is reproduced in its entirety below:
My friend has suggested that the appellant has
not satisfied the requirements under subsection 247(3) with respect to
contemporaneous documentation. And we totally disagree with that. The letter
that we sent on July 9th, 2003, which I believe -- dated July 9, 2003 and can
be found at tab 54. I'm not going to belabour the point. We went through it,
what was enclosed in there. And at the end I note:
"I trust the foregoing is the information
you require. If you need any elaboration on the enclosed material please don't
hesitate to give me a call."
We heard nothing, nothing, for 11 months.
[231] This is not persuasive enough to overwhelm the force of the
Respondent’s argument which in my view, is logically presented and well
supported by the evidence. Accordingly, should a finding be required in respect
of the application of subsection 247(4) after the Minister has made her
reconsideration and reassessment, I find that the Appellant has failed to
provide records or documentation that fulfil the requirements of subparagraphs
247(4)(a) and specifically, that the July 9, 2003 Response is not
sufficient to satisfy subparagraphs 247(4)(a)(v) and (vi). Accordingly,
the Appellant is deemed not to have made reasonable efforts to determine and
use arm's length transfer prices and is liable to a penalty in respect of the 2001
taxation year under subsection 247(3).
VI. Costs
[232] Counsel for the Appellant submitted that should the appeals be
allowed, the Appellant ought to be awarded party-and-party costs. The primary basis
for the Appellant’s request was that the failure of the federal Crown to secure
the attendance of the Primary Auditor at examination for discovery caused the
Appellant costs that could easily have been avoided.
[233] As noted earlier in these Reasons for Judgment, the Primary Auditor,
who retired before discoveries could be conducted, declined to attend as the
Respondent’s nominee at discovery because government policy dictated that he be
paid less than what his full salary had been prior to retirement. As a result,
another nominee had to be selected and discoveries were adjourned for
approximately four months to permit the Nominee Auditor to prepare.
[234] In requesting special costs, counsel for the Appellant did not
attribute any fault to either counsel for the Respondent or the Primary Auditor
for his decision not to attend. His contention was that the federal Crown ought
to be held to account because the additional amount it would have had to pay to
secure the Primary Auditor’s attendance was minimal in comparison with the
resulting additional costs incurred by the Appellant.
[235] As a result of the Crown’s actions, counsel for the Appellant
argued, the Appellant was unnecessarily required to spend time on the issue of
the “admissions” made by the Nominee Auditor and
their effect on the Minister’s reassessments. Counsel for the Appellant further
contended that the Crown’s refusal to fund the Primary Auditor’s attendance required
the Appellant to bring a motion seeking to prevent the Primary Auditor from
testifying at the hearing. Counsel went on to say that when he:
… did get Mr. Stasiewski [the Primary Auditor]
in the witness box, … even when presented with compelling evidence that there
was direction, certain activities were undertaken, he stayed intransigent
on his position that there was no evidence of any contribution being made by
SII and SWI. So he went through a long battle to gain nothing” [Emphasis added.].
[236] The second concern driving the Appellant’s request for special costs
was “the failure on the part of the Crown to provide an
expert’s report that complied with even the basic standards of admissibility”. Counsel noted that even
though he had gone on the record on the first day of the hearing regarding the
Appellant’s belief “that [the] report was fundamentally
flawed, [the Respondent] persisted”.
[237] In my view, there is no merit to any of the Appellant’s arguments in
support of its request for special costs. Beginning with the Respondent’s
expert report, although the Appellant’s argument for its exclusion was granted,
it was open to the Respondent to challenge the Appellant’s objection to its
admission, leaving it for the Court to decide its admissibility.
[238] As for the Primary Auditor’s non-attendance at discovery and the
Appellant’s contentions regarding the attendant consequences thereof, in my
view, counsel for the Appellant is, again, overstating the matter. It was the
Appellant’s choice to object to the Primary Auditor’s being called as a witness
and in the end, that motion was dismissed.
[239] As for the Primary Auditor’s refusal to accept the Appellant’s representations
of the roles played by Mr. Csumrik, SWI and SII, it is simply incorrect for
counsel for the Appellant to characterize the Primary Auditor’s behaviour as
“intransigent”. The Primary Auditor accepted the answers of the Nominee Auditor
on examination for discovery and his responses conformed to the Respondent’s undertaking
to the Court not to resile, in any way, from the position taken by the Nominee
Auditor at examination for discovery. The Primary Auditor acknowledged that Mr.
Csumrik, SWI and SII may have been a little more involved in the Appellant’s
marketing efforts than he found them to be during the audit but remained firm that
there was still insufficient proof to justify the amounts paid to SII by the
Appellant. I must say, having carefully reviewed the same documents and having
had the added benefit of hearing the sworn evidence of the Appellant’s
witnesses, I have reached the same conclusion.
[240] For the reasons set out above, there is no reason for the Court to
exercise its discretion to award special costs.
[241] In view of the Appellant’s limited success in these appeals, costs
are awarded to the Respondent.
VII. Conclusion
[242]
In accordance with the Reasons for
Judgment attached, the appeals of the 2000 and 2001 taxation years are allowed,
in part, and the reassessments are referred back to the
Minister of National Revenue for reconsideration and reassessment on the basis
that an arm’s length’s party would have paid an amount to
Starline International Inc. that exceeded the fees paid by Starline
International Inc. to Starline Windows Inc., but only in the amount of US$32,500
in each of 2000 and 2001.
[243] In view of the Appellant’s limited success in these appeals, costs
are awarded to the Respondent.
Signed
at Ottawa, Canada, this 10th day of June 2014.
“G. A. Sheridan”