CRA announces that it successfully applied transfer pricing penalties to an inbound hybrid loan
CRA provided a cryptic diagram portraying a borrowing by Canco of, say, $100M from U.S. parent (a C Corp) at, say, 10% interest, with Canco funding the cash interest payments of $10M p.a. through the receipt of those sums as prepayments under agreements for the forward sale of treasury shares by it to a U.S. LLC subsidiary of U.S. parent (which, in turn, funds the payments by LLC under the prepaid forwards by annually contributing $10M to LLC). This arrangement presumably was targeted to not generate interest income in the U.S., and an interest deduction to Canco.
After noting that it had “resolved a file regarding a hybrid mismatch arrangement involving the deduction of non-arm’s length interest in a series of transactions that included a forward subscription agreement (outlined in the diagram …) on the basis that paragraphs 247(2)(b) and (d) … and transfer pricing penalties applied,” CRA stated:
It is the CRA’s general view that such transactions are undertaken primarily to obtain a tax benefit and that they would not be undertaken by parties dealing at arm’s length. When the CRA finds transactions similar to the example …, the Transfer Pricing Review Committee will be consulted regarding the application of paragraphs 247(2)(b) and (d). Where these paragraphs apply, related transfer pricing penalties will generally apply on the basis that taxpayers engaging in this type of tax planning did not use reasonable efforts to use arm’s length prices, terms and conditions in their transfer pricing.
This is odd. Once CRA acknowledges that interest on the loan is deductible and that the only issue is whether the interest rate exceeds the arm’s length standard, the fact that Canco used commercially unusual arrangements to fund its interest payments becomes irrelevant. The question as to whether s. 247(2)(d) can or should be applied here to rejigger the loan terms so as to support CRA arguments for a lower arm’s length rate is no different here than where there is a plain vanilla inbound unsecured "covenant lite" loan. As to whether the interest rate should reflect implicit parent credit support, see General Electric, ENMAX and Chevron, see also McKesson.
Neal Armstrong. Summary of CRA Notice to Tax Professionals, 7 July 2019 under s. 247(2)(d).