“Accurate delineation” approach in 2017 OECD Guidelines is in fact an economic substance approach (pp. 21:11-12)
The 2017 guidelines allow a written contract between the parties (“Parent” and “Subsidiary”) to be disregarded on the basis of, among other things, one party’s (for example, Subsidiary’s) lack of capacity to perform the contract or bear the contractual risks on its own. This approach incorrectly assumes that Subsidiary cannot enter a second contract (with Parent or another party) to assist it in performing its obligations or bearing risk under the first contract, and therefore incorrectly assumes that Subsidiary will not perform or bear the risk under the first contract. In such circumstances, the 2017 guidelines state that a factual adjustment is being made to disregard the first contract, because Subsidiary did not perform or bear risk under the first contract. However, if Subsidiary has entered into a second contract to assist it in performing its obligations or bearing the risk under the first contract, and thereby performs its obligations or bears risk under the first contract, disregarding the first contract is an economic substance adjustment
This is demonstrated by the following example in paragraph 1.48 of the 2017 guidelines, which purports to illustrate a factual adjustment based on the conduct of the parties, but actually illustrates an economic-substance adjustment.
Company S is a wholly-owned subsidiary of Company P. The parties have entered into a written contract pursuant to which Company P licenses intellectual property to Company S for use in Company S’s business; Company S agrees to compensate Company P for the licence with a royalty. Evidence provided by other economically relevant characteristics, and in particular the functions performed, establishes that Company P performs negotiations with third-party customers to achieve sales for Company S, provides regular technical services support to Company S so that Company S can deliver the contracted sales to its customers, and regularly provides staff to enable Company S to fulfil customer contracts. A majority of customers insist on including Company P as a joint contracting party along with Company S, although fee income under the contract is payable to Company S. The analysis of the commercial or financial relations indicates that Company S is not capable of providing the contracted services to customers without significant support from Company P, and is not developing its own capability. Under the contract, Company P has given a licence to Company S, but in fact controls the business risk and output of Company S such that it has not transferred risk and function consistent with a licensing agreement, and acts not as the licensor but the principal. The identification of the actual transaction between Company P and Company S should not be defined solely by the terms of the written contract. Instead, the actual transaction should be determined from the conduct of the parties, leading to the conclusion that the actual functions performed, assets used, and risks assumed by the parties are not consistent with the written licence agreement.
This accurate delineation is an economic-substance adjustment because it disregards the legal form and legal substance of the actual transaction (licence) and replaces it with the form of the expected transaction (principal-agent relationship). It bases this adjustment on the facts that “Company S is not capable of providing the contracted services to customers without significant support from Company P,” and Company P “controls the business risk and output of Company S such that it has not transferred risk and function consistent with a licensing agreement.”
In the foregoing example, it would be more appropriate to make factual adjustments to identify all of the distinct contracts in addition to the licence: commission sales provided by Company P to Company S, technical services provided by Company P to Company S, and guarantee fees for Company P being a signatory to customer contracts. …
S. 247 does not contemplate the OECD “accurate delineation” approach (pp. 21:13-14)
[T]he 2017 guidelines permit the recharacterization of transactions on the basis of economic substance using the concept of accurate delineation. In contrast, section 247 of the Act was never intended to permit transactions to be characterized or recharacterized on the basis of economic substance. As a result, the accurate-delineation approach under the 2017 guidelines is not permitted under Canadian law where it characterizes or recharacterizes transactions on the basis of economic substance. Nevertheless, the Canadian government has repeatedly stated that it has adopted the 2017 guidelines and that those guidelines merely clarify, and do not significantly change, the arm’s-length principle.
… [I]f the Canadian government wants to adopt the 2017 guidelines, it must amend section 247. The courts should resist any attempt to stretch section 247 beyond its intended limits, as the Tax Court of Canada did in Cameco.
Difficulties in applying the accurate-delineation approach to transactions with U.S. (p. 21:20)
[T]he accurate-delineation approach under the 2017 guidelines … can be used, among other things, to characterize or recharacterize a transaction into an entirely different transaction with different tax consequences in a normal (as opposed to an exceptional) circumstance.
These concerns are particularly acute in regard to controlled transactions between Canada and … the United States … . For example, we understand that in the example in paragraph 1.48 of the 2017 guidelines…the United States would respect the licence and price it accordingly. [fn 104: 4 See Jim Fuller and David Forst, “US Inbound: BEPS Transfer Pricing Rules May Conflict with US TP Rules,” International Tax Review, March 23, 2017] If Canada treated the entire arrangement as an agency, the dispute would be difficult to resolve through competent authorities.
- The approach taken in the 2017 OECD Guidelines of “accurately delineating” a transaction is, in fact, an approach of departing from the contracts and characterizing the cross-border transaction in accordance with its economic substance. This can be seen, for instance, in the example in para. 1.48 of the 2017 Guidelines respecting a parent which licenses IP to a subsidiary (Company S) but, under the OECD’s accurate-delineation approach, it is found that it “in fact controls the business risk and output of Company S such that it has not transferred risk and function consistent with a licensing agreement, and acts not as the licensor but the principal” so that the “actual transaction” differs from the written contract. It is suggested that:
In contrast, section 247 of the Act was never intended to permit transactions to be characterized or recharacterized on the basis of economic substance. As a result, the accurate-delineation approach under the 2017 guidelines is not permitted under Canadian law where it characterizes or recharacterizes transactions on the basis of economic substance. Nevertheless, the Canadian government has repeatedly stated that it has adopted the 2017 guidelines and that those guidelines merely clarify, and do not significantly change, the arm’s-length principle.
- It would be problematic if CRA thus sought to apply an accurate-delineation approach to cross-border transactions with the U.S. For example, in the above example, it is understood that:
the United States would respect the licence and price it accordingly. If Canada treated the entire arrangement as an agency, the dispute would be difficult to resolve through competent authorities.
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