Dropping of explicit "recharacterization" reference and addition of non-tax purpose test to revised s. 247(2) (p. 1168)
In response to criticism from commentators of the September 1997 draft, the final version of the legislation prepared by the Department of Finance eliminated the right to "recharacterize" (but retained the right to "adjust... the quantum or nature" of intercompany payments, which might be recharacterization by another name, and explains why the rule is conventionally referred to as the recharacterization rule). The final version also included the stipulations that the transaction would not have been entered into by persons dealing at arm's length and the transaction "can reasonably be considered not to have been entered into primarily for bona fide purpose other than to obtain a tax benefit."
Per OECD, Art. 9 permits recharacterizing debt where it is equity in economic substance (pp. 11176-7)
[T]he [Canada Revenue Agency] information circular [87-2R] notes that "Section 247 is intended to reflect the arm's length principle expressed in the OECD Guidelines." It also states the following:…
As a general rule, specific provisions of the Act—relating to loans and other indebtedness to or from non-residents, which are contained in sections 17 and 80.4, subsections 15(2) and 18(4)—would be applied before considering the more general provisions of section 247. These specific provisions deal with situations in which a Canadian corporate taxpayer:…
- is thinly capitalized
As noted in the CRA's information circular, the Canadian recharacterization provisions are intended to encompass the concept of recharacterization set out by the OECD in the 1995 transfer-pricing guidelines. The relevant portions of the guidelines (taken from the 2010 version) read as follows:…
[I]n other than exceptional cases, the tax administration should not disregard the actual transactions or substitute other transactions for them….
However, there are two particular circumstances in which it may, exceptionally, be both appropriate and legitimate for a tax administration to consider disregarding the structure adopted by a taxpayer in entering into a controlled transaction. The first circumstance arises where the economic substance of a transaction differs from its form….An example of this circumstance would be an investment in an associated enterprise in the form of interest-bearing debt when, at arm's length, having regard to the economic circumstance of the borrowing company, the investment would not be expected to be structured in this way….
The second circumstance arises where, while the form and substance of the transaction are the same, the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner and the actual structure practically impedes the tax administration from determining an appropriate transfer price. An example of this circumstance would be a sale under a long-term contract, for a lump sum payment, of unlimited entitlement to the intellectual property rights arising as a. result of future research for the term of the contract…
A non-resident parent's decision to (re)capitalize a Cdn. Sub lacks the attributes of an arm's length transaction, so that this unexceptional transaction should be addressed solely by the thin cap rule (p. 1192)
[R]egardless of the initial capital structure choices, it could be argued that it is always possible to recapitalize the Canadian subsidiary to the maximum extent permitted under subsection 18(4). A parent company's decision to capitalize a subsidiary corporation is not something that could (ever) be undertaken by arm's-length parties; this explains why the Act provides for annual testing of the deductibility of the subsidiary's interest under subsection 18(4) in accordance with the then-prevailing policy of the Department of Finance regarding the permitted debt-to-equity ratio.
Because the Canadian thin capitalization rules use an arbitrary ratio, there will necessarily be some winners and some losers on the basis of industry norms (leaving aside a treaty-based argument when a Canadian borrower is underleveraged by industry standards but otherwise restricted by the thin capitalization rules). We believe that there is a strong argument to be made when the Canadian borrower is overleveraged by industry standards (and there is no issue with the character of the equity), but is compliant with the thin capitalization rules, there is little scope for paragraph 247(2)(b) or (d) to adjust the nature of the interest payment on the intercompany debt. If this were not the case, the application of paragraph 247(2)(b) or (d) would have the effect of indirectly modifying the statutory ratio.
Would the arm's length version of a (recharacterized) transaction change post-implementation (p. 1201)?
[T]he CRA would not be concerned with an increase in the Canadian subsidiary's equity on account of greater retained earnings (regardless of their cause, whether better-than-expected market performance or improved operating conditions). It is therefore difficult to see why declines in the equity value on account of the inverse of these types of factors should matter (as long as they do not represent returns of capital to a non-resident shareholder).
In discussing advance pricing arrangements at paragraph 4.125 of the 2010 transfer-pricing guidelines, the OECD states that it would not be reasonable to assert that an arm's-length short-term borrowing rate for a certain company's intragroup debt would remain at the same rate during the entire term of an advance pricing arrangement. Similarly, regardless of the rationale for a particular capital structure when implemented, if the arm's-length version of the structure would have changed over time, the OECD's view can arguably be extended to require a dynamic approach to recharacterization.
Per OECD, Art. 9 permits recharacterizing debt where it is equity in economic substance (pp. 11176-7)
[T]he [Canada Revenue Agency] information circular [87-2R] notes that "Section 247 is intended to reflect the arm's length principle expressed in the OECD Guidelines." It also states the following:…
As a general rule, specific provisions of the Act—relating to loans and other indebtedness to or from non-residents, which are contained in sections 17 and 80.4, subsections 15(2) and 18(4)—would be applied before considering the more general provisions of section 247. These specific provisions deal with situations in which a Canadian corporate taxpayer:…
- is thinly capitalized
As noted in the CRA's information circular, the Canadian recharacterization provisions are intended to encompass the concept of recharacterization set out by the OECD in the 1995 transfer-pricing guidelines. The relevant portions of the guidelines (taken from the 2010 version) read as follows:…
[I]n other than exceptional cases, the tax administration should not disregard the actual transactions or substitute other transactions for them…
.
However, there are two particular circumstances in which it may, exceptionally, be both appropriate and legitimate for a tax administration to consider disregarding the structure adopted by a taxpayer in entering into a controlled transaction. The first circumstance arises where the economic substance of a transaction differs from its form….An example of this circumstance would be an investment in an associated enterprise in the form of interest-bearing debt when, at arm's length, having regard to the economic circumstance of the borrowing company, the investment would not be expected to be structured in this way….
The second circumstance arises where, while the form and substance of the transaction are the same, the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner and the actual structure practically impedes the tax administration from determining an appropriate transfer price. An example of this circumstance would be a sale under a long-term contract, for a lump sum payment, of unlimited entitlement to the intellectual property rights arising as a. result of future research for the term of the contract…
A non-resident parent's decision to (re)capitalize a Cdn. Sub lacks the attributes of an arm's length transaction, so that this unexceptional transaction should be addressed solely by the thin cap rule (p. 1192)
[R]egardless of the initial capital structure choices, it could be argued that it is always possible to recapitalize the Canadian subsidiary to the maximum extent permitted under subsection 18(4). A parent company's decision to capitalize a subsidiary corporation is not something that could (ever) be undertaken by arm's-length parties; this explains why the Act provides for annual testing of the deductibility of the subsidiary's interest under subsection 18(4) in accordance with the then-prevailing policy of the Department of Finance regarding the permitted debt-to-equity ratio.
Because the Canadian thin capitalization rules use an arbitrary ratio, there will necessarily be some winners and some losers on the basis of industry norms (leaving aside a treaty-based argument when a Canadian borrower is underleveraged by industry standards but otherwise restricted by the thin capitalization rules). We believe that there is a strong argument to be made when the Canadian borrower is overleveraged by industry standards (and there is no issue with the character of the equity), but is compliant with the thin capitalization rules, there is little scope for paragraph 247(2)(b) or (d) to adjust the nature of the interest payment on the intercompany debt. If this were not the case, the application of paragraph 247(2)(b) or (d) would have the effect of indirectly modifying the statutory ratio.
Would the arm's length version of a (recharacterized) transaction change post-implementation (p. 1201)?
[T]he CRA would not be concerned with an increase in the Canadian subsidiary's equity on account of greater retained earnings (regardless of their cause, whether better-than-expected market performance or improved operating conditions). It is therefore difficult to see why declines in the equity value on account of the inverse of these types of factors should matter (as long as they do not represent returns of capital to a non-resident shareholder).
In discussing advance pricing arrangements at paragraph 4.125 of the 2010 transfer-pricing guidelines, the OECD states that it would not be reasonable to assert that an arm's-length short-term borrowing rate for a certain company's intragroup debt would remain at the same rate during the entire term of an advance pricing arrangement. Similarly, regardless of the rationale for a particular capital structure when implemented, if the arm's-length version of the structure would have changed over time, the OECD's view can arguably be extended to require a dynamic approach to recharacterization.
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