Re Nortel Networks Corp., 2014 ONSC 6973

Under Nortel's transfer pricing methodology, the entities performing R&D, including Nortel itself and a UK subsidiary, were entitled to all residual profits after payment of returns to the Nortel subsidiaries that performed sales and distribution functions. The related agreement specified that restructuring costs incurred by each R&D subsidiary were not to be shared.

Following Nortel's insolvency, Newbould J. rejected various submissions made by the administrators of the pension plan for the UK subsidiary respecting transfer pricing, including that this arrangement failed to properly compensate the UK subsidiary for its restructuring costs. He accepted the monitor's position that "Chapter 9 of the OECD Guidelines explicitly frames the issue of restructuring costs and benefits as a question of ex ante risk allocation by way of an intercompany contract, rather than an ex post examination of who should bear the realization of a risk (i.e., restructuring costs)." Furthermore, the approach of the claimants' expert that "one starts with the economic substance and then looks to see if the legal form follows the economic substance" was "the opposite of what the OECD Guidelines call for."

See summary under Treaties – Art. 9.

In January 2009, Nortel Networks Corporation ("NNC"), which was the publicly-traded Canadian parent filed for protection under the CCAA, various U.S. subsidiaries filed for protection under chapter 11 of the U.S. Bankruptcy Code and its principal UK subsidiary ("NNUK") and most other European subsidiaries entered into administration under the U.K. insolvency laws. "R&D was the primary driver of Nortel's value and profit" (para. 8). Under Nortel's transfer pricing methodology, the entities performing R&D, including NNL and NNUK, were entitled to all residual profits after payment of returns to the Nortel subsidiaries that performed sales and distribution functions. In particular, under a Master Research and Development Agreement ("MRDA"), a residual profit split method was specified whereby each such performer of R&D was allocated a portion of a residual profit pool based on its percentage of yearly global R&D expenditures (para. 10). This methodology was supported by advance pricing agreements with the tax authorities in Canada, the U.S. and the U.K. (para. 132). The MRDA also specified that restructuring costs incurred by each R&D subsidiary were not to be shared (para. 137).

Newbould J. rejected the submission made by the administrators of the pension plan for NNUK made (at para. 130) "that the Nortel transfer pricing arrangements failed to compensate NNUK for the true contributions it was making to the Nortel Group …[and] in particular they … failed to properly compensate NNUK for its restructuring costs and its pension costs." He noted (at para. 134) that "the OECD Guidelines provide in section 1.64 and 1.65 that an examination of a controlled transaction should be based on the transaction actually undertaken by the associated enterprises as it has been structured by them except in two exceptional cases [respecting departures from economic substance or no commercial rationality]" and accepted (at para. 135) testimony of the monitor's expert that "neither of the exceptional cases…existed and thus in accordance with those guidelines the MRDA should stand and was dispositive of the issues." Conversely, the claimants' expert:

said that one starts with the economic substance and then looks to see if the legal form follows the economic substance. That is the opposite of what the OECD Guidelines call for (para. 139).

Furthermore:

What he [the claimants' expert] has done is look at events after the time when the arrangements were made by the parties in the MRDA. As Dr. Reichert [for the monitor] explained, Chapter 9 of the OECD Guidelines explicitly frames the issue of restructuring costs and benefits as a question of ex ante risk allocation by way of an intercompany contract, rather than an ex post examination of who should bear the realization of a risk (i.e., restructuring costs). (para. 142, see also para. 149)