New

“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.

Overview (p. 188)

[A] textual, contextual, and purposive analysis of section 247 and other Canadian transfer-pricing provisions, in particular subsections 69(1) and 17(1), suggests that, contrary to [2017-0691191C6], Canada's transfer-pricing rules apply to a transaction between two parties that are non-residents of Canada only to the extent that at least one of the parties carries on business in Canada or disposes of taxable Canadian property, and only where the transfer-pricing analysis is relevant to one of those activities or transactions….

Judicial limitation of “taxpayer” (pp. 190-194)

Since none of the … definitions of “taxpayer," "person," or "partnership' differentiates between resident and non-resident entities, one may presuppose that these terms may include both a domestic and a foreign entity in every context.

However,…the term must be interpreted in context. … Office Overload … held that the vendor was not a "person” for the purposes of section 85D, on the basis that the provision was intended to apply only to persons who "fall to be taxed or otherwise dealt with under the provisions of the Canadian Income Tax Act and who report to the Canadian Government the income arising from the operation of the business…

Holiday Luggage … held that a corporation referred to in section 256 did not include a non-resident corporation that did not carry on business in Canada.

Lea-Don Canada … held that

… It is clear that s. 20(4) is concerned with taxpayers entitled to a deduction, not with persons who are not subject to assessment under Part I. A non-resident not carrying on business in Canada is not a person entitled to such a deduction and therefore s. 20(4) cannot properly be said to be "applicable" to him.

Oceanspan … stated:

[A] non-resident without income from Canadian sources can never be liable to pay tax under the Act on its foreign income. It is not, therefore, a corporation contemplated by the definition of "taxpayer" in the Act….

Merali … held that the respondent had been a "taxpayer" during the non-resident period because he had been subject to Canadian tax during that period under subsection 216(1) and had previous "taxation years" under paragraph 111(1)(a),…

From the foregoing cases, it may be stated as a general proposition that a person is not a "taxpayer" unless the person comes within the charging provisions of the Act—that is, the person is resident in Canada, carries on business in Canada, or disposes of taxable Canadian property….

Change to “taxpayer” from “carrying on business” in s. 247 (p. 198-199)

Subsections 69(2) and (3) were repealed with the enactment of section 247 in 1998. The reference to a "taxpayer carrying on business in Canada" in subsections 69(2) and (3) was replaced by a reference to only a "taxpayer" in section 247. …[A]nalysis of contemporaneous external sources suggests that there was no intent to expand the scope of the parties to which the transfer-pricing rules apply. …

Relevance of s. 95(2)(f) (pp. 201-202)

The significance of the change [in 2009] from the computation of income “as though the affiliate were resident in Canada” in the predecessor to current paragraph 95(2)(f), to the deemed Canadian residence of an affiliate in the current version, is not clear. …

[T]he stronger argument, particularly in light of the history of the transfer-pricing rules and paragraph 95(2)(f) described above, is that current paragraph 95(2)(f) should not be taken into account in applying section 247. Irreconcilable legislative inconsistencies remain where an attempt is made to apply the two provisions together. For example, in the context of a transaction between a foreign affiliate and a Canadian taxpayer that gives rise to FAPI, if paragraph 95(2)(f) is taken into account for the purposes of section 247 to deem the foreign affiliate to be resident in Canada, paradoxically section 247 cannot apply because there will then be no "non-resident person" for the purposes of section 247. …

Problems under the more expansive interpretation of “taxpayer” (p. 206)

A number of problematic interpretive issues arise if section 247 or subsection 69(1) is applied to transactions between non-resident persons with no Canadian tax nexus….

[A] transfer-pricing adjustment can arise only for the "taxpayer" and not for the non-resident person. Further, the penalty provisions in subsection 247(3) and the contemporaneous documentation requirements in subsection 247(4) apply only in respect of the "taxpayer." …

[W]here both parties are non-resident and neither has Canadian tax nexus, there is nothing in the text of subsection 247 that indicates which party is the “taxpayer” to which the provision applies. …

[T]he contemporaneous documentation requirements in subsection 247(4) were not designed to cover transactions between two non-residents with no Canadian tax nexus. …

[W]here a foreign affiliate has earnings from an active business and the affiliate is required under the tax law of its country of residence, or the tax law of the country in which the business is carried on, to compute income, the affiliate's earnings are computed in accordance with that foreign law. Such earnings computed under foreign law are then adjusted in accordance with the items listed in regulation 5907(2), none of which relate to transfer-pricing adjustments under Canadian law. If subsection 247(2) could apply to interaffiliate transactions, it appears that earnings and surplus adjustments could be made only in respect of earnings of the foreign affiliate computed under Canadian tax rules, and not, for example, in respect of active business earnings computed under foreign law. It is not apparent why a transfer-pricing adjustment under subsection 247(2) should affect the computation of surplus in the former circumstance but not the latter.

Where profit-split method (PSM) is appropriate in transfer pricing (TP) (p. 1)

The PSM is considered to be the most appropriate method if (1) both parties to the transaction "make unique and valuable contributions"; (2) identification of reliable arm's-length comparables is a challenge; and (3) businesses operations are "highly integrated such that the contributions of the parties cannot be reliably evaluated in isolation from each other." The latter situation is often seen if both parties contribute unique intangible assets that are important to the overall success of both.

Effect of CbCR and MF in increased use of PSM (p. 1)

The use of the PSM is expected to increase… .

[F]or TP practitioners, BEPS took the form of country-by-country reporting (CbCR) and the requirement to produce a master file (MF) as part of the OECD's recommendation of a three-tiered approach to TP documentation. CbCR requires an MNC to disclose the tax jurisdictions in which it operates and the relative profitability of each jurisdiction as well as other information, such as head count and related and unrelated revenues. The MF requires taxpayers to disclose the drivers of business profits, such as a description of the supply chain and intellectual property used within the MNC group. Tax authorities, armed with the additional information available through the CbCR and the MF, are expected to use the PSM as either a primary or a secondary TP method to assess the reasonableness of the TP policies that are applied by an MNC.

Desire for 2-sided analysis favoring TPM (pp. 1-2)

[A] one-sided TP analysis hypothesizes that if the tested party (the so-called simpler related entity) earns an arm's-length return that is appropriate for its functional characterization, then the other related entity is assumed to earn an arm's-length return, too. The lack of transparency has caused tax authorities to be concerned and skeptical, particularly because there is no visibility of the profitability of the other related entity. The PSM, in contrast, is a two-sided analysis that evaluates the overall system profit earned by related entities and considers whether the profit split between related entities, on the basis of their relative contributions, is appropriate.

CRA intent to apply the 2017 Transfer Pricing Guidelines to pre-2017 taxation years (pp. 10-11)

The CRA indicated [in 2018 CTF Rouundtable, Q.4] that it will apply the 2017 Transfer Pricing Guidelines [OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017 (July 10, 2017)] to pre-2017 taxation years, as well as to the interpretation of treaties entered into post-2017. However, the CRA does not consider such an application to be retroactive, due to its characterization of the 2017 Transfer Pricing Guidelines as merely an elaboration on the prior guidance. …

As noted…in Prévost Car…later guidance from the OECD can be helpful to the interpretation and application of existing bilateral tax treaties, when it "represent[s] a fair Interpretation" of the OECD Model Tax Convention (the "Model Treaty") and does not conflict with the guidance that was in place at the time a specific treaty was entered into.

New OECD “value creation” concept focuses on economic substance rather than legal relations (pp. 11- 12)

[T]he 2017 Transfer Pricing Guidelines… reoriented transfer pricing as revolving around the concept of value creation… .That criterion is intended to ensure that profits are taxed where economic activities take place and value is created… .

…The OECD's attempt to deemphasize contractual allocations of functions, assets and risks represents a significant change in approach to transfer pricing — particularly if it were to be applied in countries such as Canada, that generally respect the legal form of transactions (rather than allowing a recharacterization in accordance with underlying economic substance). Recently, the Crown's approach in Cameco … was, in essence, congruent with the “value creation” concept… .

New OECD “accurate delineation” concept entails transaction recharacterization (p. 12)

The 2017 Transfer Pricing Guidelines also introduce the concept of "accurate delineation", which essentially proposes that in order to compare a transaction between associated enterprises with a comparable transaction entered into between independent parties, it is necessary to first "accurately delineate" the former transaction in light of "economically significant characteristics". However, such economically significant characteristics…include the conduct of the associated parties, the functions they perform, the assets they actually use and the risks they actually assume.

If an analysis of the above enumerated economically significant characteristics results in a delineation of a transaction that differs from that entered into under the contract between the associated enterprises, the accurate delineation principle would then ignore the contractual transaction in the comparability analysis, instead focusing on the "accurately delineated" transaction….

OECD recharacterization approach includes treating debt as equity (p. 13)

[I]n the OECD’s recent [Discussion Draft on Financial Transactions released July 3, 2018] … an example is … given of a purported loan being accurately delineated as equity, chiefly because of a low likelihood of repayment within the specified term. However, under Canadian law, the nature of an instrument as debt or equity is determined by general legal principles, pursuant to which the form or label attached to an instrument can be overturned only if the legal substance of the arrangement is clearly different, not because the economics are such, that an arm's length party might have chosen to subscribe for shares rather than make a loan.

Departure of new guidelines from s. 247 (p. 14)

Not only do these new concepts in the 2017 Transfer Pricing Guidelines depart from the 1995 Transfer Pricing Guidelines, they also have little grounding in section 247 of the ITA or Canadian transfer pricing case law. …

Further, the 2017 Transfer Pricing Guidelines' "accurate delineation" concept could cause recharacterization in a domestic Canadian transfer pricing dispute under paragraphs 247(2)(a) and (c) of the ITA in circumstances where not even the explicit mandate in the ITA's transfer pricing recharacterization rule … would do so. Pursuant to paragraphs 247(2)(b) and (d) of the ITA, the [rule] only permits recharacterization of controlled transactions if arm's length parties-would not have entered into such transactions and a tax avoidance motive test is satisfied….

[A]lthough the OECD’s guidelines may be relevant for interpretative purposes, they do not override domestic Canadian law….

OECD cash box notion

[T]he Cameco case…effectively rejected the OECD/base erosion and profit-shifting “cash-box” outrage…

[T]he “cash-box” notion not only effectively makes an investment manager the majority partner in the property being managed and reduces the interest of the party whose capital is at risk to a “risk-free” return, but totally ignores the discipline of investment markets and arrangements that sees the brightest and best private equity managers earn no more than a 20 percent “carry”.

Implicit Cameco rejection of cash box notion

[T]he issue is squarely dealt with in paragraphs 455 and 456 of the judgment where taxpayer expert witnesses were quoted as saying (in paragraph 455), "Thus to argue, as [the Canada Revenue Agency] does, that the provision of administrative services to investors like CEL who supply risk capital is the equivalent of bearing the risks that capital is subject to is to denigrate the role of risk bearing while putting the engagement in routine functions on a pedestal," and (in paragraph 456), "Even if the CRA's assertion that CCO monitored and managed CEL's price risk is true, this is irrelevant to the question as to who bore the price risk. The CRA confuses risk monitoring with risk-bearing."

Alignment with OECD Guidelines (pp. 32:2-3)

[N]o Canadian legislation could explicitly refer to [the OECD] guidelines, nor indeed to any other requirements or guidance that a tax authority, Finance, or Canada as the tax jurisdiction could not technically control. For this reason, the legislation uses words that accomplish alignment with the OECD guidelines without referring specifically to them. The guidance that accompanied the legislation stated that the government recognized that preparing documentation should not impose an undue burden on taxpayers and that a balance must be struck between benefits for taxpayers and the CRA. and the timely preparation of transfer-pricing information….

OECD guidelines (p. 24)

The OECD Guidelines do, however, have persuasive force in Canada. In Glaxo [2012 SCC 52], the provision of the Income Tax Act did not itself provide guidance in defining the "reasonable amount" paid in an arm's length context, so the Court turned to the OECD Guidelines. The Court referred to the OECD Guidelines (1979) and the OECD Guidelines (1995) to consider different transfer pricing methods. These in turn informed the Court's decision under the Income Tax Act.

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.

Release of OECD Discussion Draft of TPSM (p. 98)

The Organisation for Economic Co-operation and Development (OECD) recently released its draft public discussion paper on the application of the Transactional Profit Split Method (TPSM) to global value chains… .

[T]he TPSM is intended to divide the profits between the parties on the basis of how much value each party contributed to the transaction, which is presumed to reflect an arm's-length division.

Code s. 482 accommodation of transfer pricing at entity level (p. 100)

Unlike the Canadian transfer pricing provision, the American provision only requires the taxing authority to conclude that an allocation of amounts is necessary to prevent evasion or to clearly reflect the parties' income or profit. No specific terms or conditions relating to individual transactions need be identified; the situation can be assessed on an aggregate entity profit level.

OECD Model, Art. 9 accommodation of considering overall commercial relations (p.101)

As with the American provision, Article 9 does not require consideration of particular transactions but rather the overall commercial or financial relations between two enterprises. The requirement under the Canadian provision that specific terms and conditions in relation to individual transactions be identified and adjusted present a potential barrier to using the TPSM in the Canadian context.…

Incompatibility of ss. 247(2)(a) and (c) with TPSM (p. 101)

[I]n the complex transactions for which the TPSM is particularly suited, it will not always be possible to use the TPSM to reverse-engineer specific prices, terms, and conditions for each transaction and participant in the manner required by paragraphs 247(2)(a) and (c)….

Although the TPSM is theoretically applicable to individual transactions, in practice it is often sought to be applied to assess profits and contributions at an aggregate transaction or even enterprise level due to the lack of granularity in the available financial data. In such cases, it will often be unsuitable for use as a primary method in the Canadian context as it will fail to comply with the requirements of paragraphs 247(2)(a) and (c) to provide transactions or series-of-transactions level data….

Cash pooling description (p.345)

[W]e will examine a typical cash-pooling arrangement involving a Canadian subsidiary of a multinational group. Under such an arrangement, each member of the pool, including the Canadian subsidiary ("Canco"), transfers funds to, and/or receives funds from, a group member that is designated as the pool head, in this case a foreign subsidiary ("Forco") of the foreign parent corporation, resulting in intragroup payables and receivables between the pool members, including Canco and the pool head.

Primacy of specific provisions per IC 87-2R (p. 346)

[T]he transfer pricing provisions of the Act should not generally apply if the more specific provisions of the Act apply….

The CRA has interpreted that statement as meaning that the more specific provisions should be applied first before considering the application of §247. [fn 6: …2003-0033891E5] This statement is not to be taken to mean that there is an automatic exemption from the transfer pricing rules because of the mere existence of a specific provision that targets certain intra-group financing arrangements in a cross-border context; rather, the more specific provisions should be applied first and, if they do not apply, the application of the transfer pricing rules should be considered. For example, the CRA was of the view that §247(2) could apply to an outbound loan to which §17(1) did not apply by virtue of the fact that the indebtedness was not outstanding for more than one year.

Development of Berry ratio (p. 37)

E.I. DuPont de Nemours & Co., 608 F.2d 445 (Ct. CL, 1979), was an influential transfer pricing case. As an expert witness for the U.S. government, Dr. Charles Berry said that the gross margin of a distributor under arm's length prices depends on its value-added expenses as a percentage of sales. The taxpayer argued that its Swiss distribution affiliate deserved a 25% gross margin; simply because most publicly traded distributors in their sector had gross margins near 25%. While these publicly traded distributors tended to have extensive functions with operating expense-to-sales ratios near 20%, the Swiss distribution affiliate performed limited functions, with operating expenses being only 8% of sales. Dr. Berry said that since the ratio of gross profits to operating expenses for the publicly traded distributors was around the gross margin for the Swiss affiliate should be 1.25 times 8% or 10%.

Application of Berry ratio to related distributor with lower operating costs (p. 38)

Clark Chandler and Irving Plotkin discussed the use of the Berry ratio: [fn 14: "Economic issues in Intercompany Transfer Pricing" BNA Transfer Pricing Rep't. October 20, 1993]

• One problem often encountered in using gross margin data obtained from independent distributors to determine transfer prices in related-party transactions is that independent distributors may incur operating costs that are significantly higher or lower than those of the related party. Such differences in operating costs may occur because of differences in the range; of functions performed, the intensity with which they are performed, efficiency considerations (e.g., economies of scale) Or access to unique intangibles...[T]he Berry Ratio approach assumes that distributors' capital requirements vary in direct proportion to their operating expenses. While Dr. Berry makes this assumption due to the difficulty often encountered in measuring economic assets, the Berry Ratio approach is appropriate only if there is specific reason to believe that operating expenses and capital requirements are closely related. In many cases, they are not.

Off-take agreements to transfer risk to distributor (p.41)

[O]ff-take agreements are sometimes entered into to guarantee the owner of natural resources that his future revenues will provide a reasonable return on investment. The buying entity in off-take agreements agrees to pay a certain future price to the producing entity for its production. These agreements are normally negotiated prior to the construction of a facility, such as a mine, to secure a market for the future output of the facility.

The discussion above treated the producer as the entrepreneur entitled to the economic rents from the ownership of natural resources. Thus, the analysis of transfer pricing methodology treated the distributor as the tested party. In an off-take agreement, the distributor becomes the entrepreneur. Since the distributor takes the downside risk that spot prices will be below the agreed on future price, it also should receive the upside potential. Off-take agreements can, therefore, be seen as reversing which entity should be the tested party.

Examples of off-take agreemnts (pp. 41-2)

A recent example…is the arrangement between Glencore and Orbitae Aluinae Inc. …The agreement says that Glencore will purchase all of smelter-grade alumina from Orbite's proposed polan in Quebec for the first ten years of production. Glencore also recently entered into an off-take agreement with Sirius Petroleum… .Off-take agreements are widely used in the mining and oil sectors. … In other situations, they are between independent parties.

Cameco lititgation (p. 42)

Cameco Corp v. The Queen

is a transfer pricing dispute between a Canadian-based producer of uranium and the: Canadian Revenue Agency for 2003-2012 and could involve C$1.6 billion in taxes. [fn 21: Can. Tax Ct, No. 2009-2430(IT)G. See Menyasz, "Canada Tax Court Orders More Disclosure in Cameco Corp.'s Transfer Pricing Dispute," BNA Int'l Tax Monitor, February 26. 2014.] A Swiss affiliate, Cameco Europe Ltd., purchased uranium from the Canadian producer at $10 per pound under a 1999 intercompany agreement in which .this price was fixed for a 17-year period. During the commodity boom, the market price of uranium rose dramatically, peaking at $140 a pound before reverting to approximately $40 a pound.

Veritas Investment Research discussed this transfer pricing issue and its tax implications in an April 2, 2013, report. The report said that Cameco's long-term contract with its Swiss marketing affiliate exposed the Swiss affiliate to the downside risk when uranium prices were low as well as the upside potential if uranium prices rose. This point is consistent with the argument herein that off-take arrangements may shift such risk to the marketing entity and away from the producer….

Commissions charged by Elk to Japanese affiliate for securing logs (p.4)

Elk Trading [fn 5: Joel A. Nitikman was counsel for Elk.]

This appeal was filed in 2012 [fn 6: TCC Appeal No. 2012-3423(IT)G.]...[fn 7: ...In addition, the Minister assessed Elk...for a failure to withhold 5% of the dividends deemed to have been paid to Emachu... .]... Elk was a Canadian company. It was related to and, hence, not dealing at arm's length with a Japanese company, Emachu. Emachu purchased logs and lumber from around the world and resold it in Japan. In 1973, Emachu had established Elk in Canada to assist in finding Canadian logs and lumber.

…For each business segment, Emachu would specify the exact logs or lumber required and the price. Elk would find that material at that price, purchase it in Canada, and then resell it to Emachu. For these services, Elk charged a commission equal to a percentage of all costs incurred in reselling the logs and lumber, including the original purchase price, insurance, freight, etc….

CRA reassessed Elk by applying transactional net margin method (p.4)

The Minister reassessed Elk. However, rather than specify what the arm's length commission should have been, the Minister applied the TNMM. As a first step, the Minister did a database search…This resulted in exactly one comparable company, a US, publicly listed company that arranged for the delivery of automobiles ("USco"). The Minister then calculated USco's Return on Total Costs ("ROTC", being the profit USco earned as a percentage of its total costs. The Minister then increased Elk's gross revenue in each taxation year until its ROTC equaled USco's ROTC.

The case law in Canada is clear that because paragraphs 247(2)(a) and (c) refer to the "terms and conditions" of a transaction, the Crown is not permitted simply to plead that the taxpayer's prices are not arm's length prices. The Crown must go further and specify exactly what the arm's length prices should have been in the taxpayer's situation. [fn 8: See ... General Electric ... .]

Implicit CRA acceptance of commission approach (p. 4)

...Elk filed a Notice of Motion...on the basis that the Crown's Reply had no reasonable prospect of success.

The Crown has now filed a Consent to judgment allowing the appeal in full, with costs. This is, essentially, an admission that the TNMM, at least in the manner in which it is used in this case, cannot apply under the "terms and conditions" rule in paragraphs 247(2)(a) and (c)….

Objective of s. 247

20:3 The main objective in introducing new part XVI.1 [of the Act] was to enshrine the ALP [arm's length principle] in the Act's TPRs [transfer-pricing rules], thereby leaving no doubt about the standard by which the Act prices, and thus measures a taxpayer's income from, controlled transactions.

20:4 Taken literally, the ALP establishes an unattainable goal: in the absence of a Star-Trek-like holographic simulator or a quantum leap in game theory computer modelling, it is not possible to determine how the parties to the transaction would have priced the transaction had they been dealing with each other at arm's length.

Absence of "in the circumstances"

20:5 In this regard, one rather notable omission that distinguishes subsection 247(2) from its predecessors is the lack of any explicit reference to the price that would have been used "in the circumstances" had the parties to the controlled transaction been dealing with each other at arm's length. The reason for this omission, we submit, is that the quoted words are implicit in the comparative exercise mandated by the explicit adoption of the ALP in subsection 247(2).

Exclusion of non-commercial transactions

20:8 Article 9 of the OECD model convention is concerned with the pricing of "commercial" and "financial" transactions, and the guidance provided by the OECD with respect to article 9 and the ALP is aimed at those kinds of transactions. Accordingly, part XVI.1 of the Act, in our view, is not intended to apply to transactions that take place outside of a commercial context (such as cross-border gifts between siblings), despite the fact that, on its face, subsection 247(2) makes no distinction between commercial and personal transactions. Finance had contemplated expressly limiting subsection 247(2) to "commercial" transactions but feared that any such limitation could be exploited by taxpayers and, in any case, had been assured by the CRA that the TPRs would be applied only in a commercial setting.

Scope of recharacterization provision

20:17-18 The OECD guidelines state that there are two circumstances in which it may, exceptionally, be appropriate for tax administrators to recharacterize controlled transactions: ...

The first such circumstance arises where the economic substance of a transaction differs from its legal form. ... We understand that the incorporation of such a test into the TPRs was considered by Finance and rejected for a number of reasons.

The main reason for eschewing an economic substance test in the transfer-pricing context was that it conflicted with the way Canada generally taxed under the Act.

20:19 The second circumstance identified by the OECD guidelines occurs where "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 madder and the actual structure practically impedes the tax administration from determining an appropriate transfer price.

The second circumstance thus has two components. First, the transaction must be one that, when viewed as a whole, would not have been entered into by independent enterprises behaving in a commercially rational manner. In other words, the transaction must be one that is manifestly contrary to the commercial interests of the relevant party. Second, the transaction must have been structured in this commercially irrational manner in order to impede the tax authorities' ability to determine an arm's-length price under normal TPRs or to achieve some other tax benefit for the party. The application of normal TPRs is impeded because there are no arm's length comparables upon which to base a transfer-pricing assessment.

20:24-25 [T]he recharacterization rule in paragraph's 247(2)(b) and (d) is an exceptional or abnormal one. To employ the normal TPR in paragraphs 247(2)(a) and (c) to effectively recharacterize transactions would turn the integrated scheme of the TPRs, the Act, and the MAP provisions of Canada's tax treaties on its head. Unfortunately–despite the negative ramifications of using paragraphs 247(2)(a) and (c) to recharacterize transactions, despite the fact that TPRs are basically intended to price (actual) controlled transactions, despite the clear statement in the OECD guidelines that recharacterization is an exceptional remedy, despite the apparent symmetry between the OECD guidelines' second circumstance and the conditions of paragraph 247(2)(b), and despite the juxtaposition of paragraphs 247(2)(a) and (c) with an overt recharacterization rule in paragraphs 247(2)(b) and (c)– that appears to be precisely what the CRA is doing... .

20:32-33 Indeed, if the CRA can recharacterize a transaction simply by adjusting the "nature" of amounts pursuant to paragraphs 247(2)(a) and (c), then recourse to the specific recharacterization provisions of section 247 and compliance with the conditions of paragraph 247(2)(b) become unnecessary. Clearly, this approach would constitute an unauthorized and unprincipled unification of Canada's dualistic transfer-pricing regime.

[There is] the occasional need to "recharacterize" a transaction, as is permitted under the OECD guidelines where the transaction differs from what independent enterprises would do and it cannot be priced according to the arm's-length principle. [fn 36: OECD Transfer Pricing Guidelines, see for example, Organisation for Economic Co-operation and Development, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Paris: OECD, July 2010), at paragraph 4.8, and Canada Revenue Agency, Transfer Pricing Memorandum TPM-09, "Reasonable Efforts Under Section 247 of the Income Tax Act," September 18, 206, at paragraph 1:65] In such a case, the tax administration may disregard the actual transaction and recast it as the one that arm's-length parties would reasonably be expected to have done. [fn 37: Paragraph 247(2)(b) of the Canadian Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended, enacts a slightly different rule, substituting a "dominant tax benefit" test for the OECD's "unpriceability," although whether these are really different is a good question. The OECD guidelines do not refer to tax avoidance in this context, but the text seems to suggest it. What about bona fide commercial transactions that have no equivalent outside the MNE? If tax authorities can neither recharacterize transactions nor apply the arm's-length principle, what are they called upon to do?] In a simple comparison case (sale or lease, for example), this sounds almost plausible, but in most cases it is sophistry.

Includes in Exhibit 2 a list of transfer pricing issues for the pharmaceutical industry which the OECD should address.

The answer is "yes."

Review of comments of Jennifer Ryan, Director of International Tax division of the CRA at 24 February 2011 OBA section meeting - "CRA adheres to the guidelines of the OECD and therefore it will be updating its current position in respect of the hierarchy of methodologies."

Failure of Finance Notes to reflect that s. 247(2.1) begins with “initial amounts” that already reflect other ITA provisions’ application (e.g., s. 18(4)) (pp. 702-703)

Example 1 seems inconsistent with the wording of section 247(2.1). It begins with an “initial amount” of C $100. However, if the initial amount is supposed to take into account all provisions of the ITA other than section 247 and the GAAR in section 245, then the initial amount should factor in the section 18(4) limitation to deny deductibility of C $10 of the C $100 of interest. Then, section 247(2.1)(b) would adjust the interest … for all relevant purposes

Facts of Example 2 in Finance Notes (p. 703)

Example 2 considers the interaction between sections 247 and 17 ITA with a scenario in which a corporation resident in Canada has a C $100 loan receivable from a non-arm’s-length non-resident corporation that is not a controlled foreign affiliate of the Canadian corporation. Interest is payable on the loan at a rate of 1 percent. The interest rate that would have been agreed to if the parties had been dealing at arm’s length with each other is 3 percent.

Double taxation where instead loan through a partnership (p. 703)

Suppose that the lender in Example 2 did not lend directly to its foreign subsidiary but rather funded a partnership that made the loan to the subsidiary or settled a Canadian trust that made the loan to the subsidiary. In either case, under the ITA with the proposed addition of section 247(2.1), it appears that there would be an addition to the income of the Canadian corporation amounting to both 5 percent on the loan and 2 percent of the loan.

Anomalous application of s. 247(2.1) where arm’s length purchase price by Canco exceeds the property’s FMV (p.704)

Consider a Canadian corporation that acquires property from a foreign parent at the cost of C $100 when its FMV within the meaning of section 69(1) ITA is C $95, and its arm’s-length price within the meaning of section 247 is only C $90. …

And what are results if the FMV is C $100 but the arm’s-length price is C $105? As in the previous case, the initial amount under either approach is C $100. Then, assuming section 247(10) is not invoked, the price increases to C $105. This brings us to a conflict the government presumably did not foresee. When the third step in section 247(2.1) is applied, the C $105 price is subject to section 69(1), which would seem to reduce the price for tax purposes to C $100 — which is not the true arm’s-length price.

Intent in Explanatory Notes to apply s. 247(2) 1^st (pp. 5-6)

It is clear from the examples in the technical notes that the intent would be to apply transfer pricing adjustments in priority to specific rules, including the thin capitalization rules and the rules concerning interest on loans from non-residents. …

Contrary direction in text that initial amounts already reflect other ITA provisions (p. 6)

However, the language in the Proposed Amendments defines the “initial amounts” as amounts “that would be determined for the purposes of this Act (if this Act were read without reference to this section and section 245) in respect of the taxpayer or the partnership for a taxation year or fiscal period.” The textual justification is not explicit for the non-application of the specific rules contemplated in the examples, in arriving at the “initial amounts,” where the mid-amble to subsection 247(2) would continue to simply dictate that these amounts are the amounts determined under the Act, but for the application of sections 245 and 247. Indeed, with the proposed repeal of subsection 24(8), the basis is unclear for excluding application of sections 65, 68, and subsections 69(1) and (1.2) in arriving at the initial amounts. It is clear from proposed subsection 247(2.1) that in calculating the “initial amounts,” it is intended for some provisions of the Act to apply only after the subsequent application, where applicable, of adjustments under subsection 247(2). But the legislative test does not provide any clarity as to which provisions apply and which do not in determining the “initial amounts.”

Potential imputation of interest under s. 247(2.1) irrespective of the operation of s. 17 (p. 5)

Subsection 247(2.1) will … affect the exceptions contained in section 17. …

[C]ross-border short-term loans that do not meet the conditions of subsection 17(8) could now be subject to an imputation of interest based on an arm's-length rate (the CRA argued this position in…2017-0691071C6…but without explicit legislative support).

Potential application of s. 247(2.1) even where Pt. XIII tax imposed (p.5)

Another situation affected is where part XIII tax has been paid on an amount owing to a corporation resident in Canada. Previously, relying on subsection 17(7), a Canadian lender would have reasonably expected not to suffer an imputation of interest in that case. However, subsection 247(2) will now apply first. This raises the possibility that an amount of interest will be included in the lender's income in addition to the recognition of a shareholder benefit for the borrower equal to the amount of the loan. …

Potential anomalies where a transaction is recharacterized for s. 17 but not s. 247(2) purposes (pp. 5-6)

Finally, section 17 has detailed deeming rules that are included in subsections 17(2) for indirect loans, 17(4) for loans through partnerships, 17(5) for loans through trusts, 17(6) for loans through partnerships and 17(11.2) for back-to-back loans. Subsection 247(2) … contains no such deeming rules, but it has a rule that may allow for recharacterization … .

[T]ransactions involving intermediaries or non-corporate entities may be more difficult to evaluate under section 247, and in some cases might be addressed only under section 17 through the operation of its deeming rules. For these more complex transactions, the prescribed rate could apply instead of an arm’s-length rate, resulting in asymmetrical treatment.

The draft legislation, whose general premise that s. 247(2) applies in priority to all other provisions of the Act, creates ambiguity as to the scope of the transfer pricing rules, as illustrated below.

• Does s. 247(2) apply to a contribution of capital made by a Canadian-resident parent to a non-resident subsidiary, or to a gift by a Canadian-resident individual to a non-resident relation? If the transfer pricing rules do apply to such transactions, this would result in the need to comply with transfer pricing documentation requirements (which would, for example, be impossible for gifts). On the other hand, if the transfer pricing rules should be “read down,” there would be a resulting unexpected and undefined narrowing of the scope of the transfer pricing rules.
• Second, draft s. 247(2.1) creates uncertainty as to the application of “rollover” rules such as ss. 85(1), 86(1) and 51(1). For example, under a s. 85(1) rollover transaction where the transferor taxpayer takes back less than fair market value consideration, the existing rules contemplate an upward adjustment to the elected amount under s. 85(1)(e.2), subject to a safe harbour. If s. 247(2) instead is applied first, s. 85(1)(e.2) arguably has no application. Moreover, it is unclear whether under s. 247(2), the taxpayer would be deemed to receive additional boot, then it would appear to have additional consideration even in circumstances where the exceptions to s. 85(1)(e.2) would have applied – whereas if the transfer pricing adjustment was additional shares, then there would be no gain under s. 85(1)(e.2).
• Third, the draft legislation reverses the long-standing CRA administrative policy to apply rules of the Act of more specific application regarding s. 17 and the thin capitalization rules in priority to the transfer pricing rules. As suggested by Example 2 in the Explanatory Notes, s. 17(1) would be rendered redundant as between non-arm’s length parties even though such non-arm’s length circumstances were “front and centre” in the design of the s. 17(1) rules – and any “safe harbour” contained in s. 17 or other specific rules may be rendered moot by the prior application of s. 247(2).
• Finally, there is still a question of circularity. The proposed amendment refers to amounts determined without reference to ss. 247 and 245. What amounts are determined for the purposes of the Act where s. 17 may be applicable? The likely intended effect would be better captured by referencing amounts determined for the purposes of applying other provisions of the Act or determined for the purposes of the Act before any adjustment by virtue of any provision of the Act. That would seem to better capture the intended effect of the proposals.

• S. 247(1.1) is circular.

Unlikelihood of a s. 247(4)(a) safe harbour (p. 32:7)

[T]he qualitative assessment of the adequacy of the actions described in subsection 247(4) lies entirely within the ambit of subsection 247(3). In other words, subsection 247(4) seems to require only a recitation of the facts that demonstrate the effort made; subsection 247(3) is where the efforts are analyzed to determine whether they were reasonable. The fact that paragraph 247(4)(a) only requires taxpayers to document what work they in fact did to determine the arm's-length transfer price or allocation—regardless whether such work represents reasonable efforts—will likely make courts reluctant to view paragraph 247(4)(a) as establishing a safe harbour.

Dichotomy between arm’s length prices and arm’s length allocation (pp. 32:7-8)

"[R]easonable efforts" in subsection 247(3) refers to the determination and use of arm's-length transfer prices or arm's-length allocations, and not to arm's-length terms and conditions, which are the subject of the main transfer-pricing provision in subsection 247(2). The term "arm's length allocation" is defined in subsection 247(1) to mean "an allocation of profit or loss that would have occurred between the participants in the transaction if they had been dealing at arm's length with each other [emphasis added]." However, the "allocation" wording is not found in subsection 247(2); it is only used in subsections 247(3) and (4). ...

Regardless whether profit allocations can be used under subsection 247(2) in circumstances where they do not permit the determination of specific terms and conditions in respect of a transaction, it is clear that they can be used as a defence against the application of transfer-pricing penalties. So if it makes sense for economic or other reasons to prepare a profit-split analysis rather than a more granular pricing analysis, and assuming that the profit allocation can be defended as flowing from the making of reasonable efforts, penalties should not be applied.

Historical reason for penalty (p. 32:8)

The historical reason for Canada's transfer-pricing penalty is clear. The United States introduced a transfer-pricing penalty before Canada did, and it was not trivial. As a result, when taxpayers were involved in cross-border trade involving Canada and the United States, they would favour recognizing more income in the United States and less in Canada, all things being equal. It was therefore necessary for Canada to level the playing field...

HSBC: Relevance of past CRA audit practices to penalty (p. 32:10)

In HSBC Bank [2007 TCC 307], the taxpayer alleged in its notice of appeal that it had used a transfer price for a decade, and despite annual audits, the CRA never challenged it until the reassessment that led to the appeal….Bowman CJ refused to strike the paragraph because, although previous years are not relevant to the issue of whether there should be a transfer pricing adjustment in a subsequent taxation year, it was not clear and obvious to him that events in previous years would not be relevant to determining whether there should be a transfer-pricing penalty in a subsequent year….

[I]n cases where a subsection 247(4) request for documentation was made, and the CRA expressed no concern with the documentation, it is entirely reasonable in those circumstances for a taxpayer to believe that it had met the acceptable standard and to continue producing similar contemporaneous documentation for subsequent years….To permit the penalty to be applied in such a case would be inappropriate and contrary to the principles of certainty, predictability, and fairness…

Reluxicorp: reasonable efforts if no carelessness (p. 32:11)

[In] Reluxicorp…Lamarre J noted that "there will be carelessness if the person failed to make reasonable efforts to comply with the Act….A technical reading of the statement also suggests that failure to make reasonable efforts is a more grievous offence than carelessness, since the existence of the former necessarily implies the existence of the latter. As a result, if a taxpayer can show that he or she was not careless, the reasonable efforts requirement should be satisfied.

Jurisprudence on “reasonable efforts” (pp. 32:12)

[I]n Barrett, the Federal Court of Appeal determined that "reasonable efforts" is a higher standard than "good faith." …

In Royal Oak Mines [[1996] 1 S.C.R. 369], the Supreme Court of Canada concluded that "reasonable effort" is an objective standard that can be assessed by reference to "comparable standards and practices within the particular industry." …

Rossiter v. Chiasson, [1950] OWN 265 (HCJ)…[stated] the party need not "go to absurd, whimsical or unwarranted lengths" since "reasonable" means " 'logical,' 'sensible' and 'fair.' " …

Crown Employees [1997 CarswellOnt 6197] explicitly held that

reasonable efforts does not mean "all efforts." It does not mean "efforts to the point of undue hardship." It does not mean "every effort." What it means is efforts that are reasonable in the circumstances all things considered. What is reasonable in the circumstances will, obviously, depend on the facts of particular cases.

Informing s. 247 penalty with OECD Guidelines (pp. 32:12-13]

[T]he fact that the CRA and the Department of Finance have both indicated that the section 247 provisions were meant to import the principles of the OECD guidelines into the Act may in some cases provide taxpayers with a basis for interpreting section 247 provisions in a manner that is less demanding than the CRA's publications would otherwise suggest. …

For example, chapter IV of the 2010 OECD guidelines provides…

[I]mposition of a sizable "no-fault" penalty based on the mere existence of an understatement of a certain amount would be unduly harsh when it is attributable to good faith error rather than negligence or an actual intent to avoid tax. …

The CRA addresses some of these points in TPM-09 but indicates, for example, that a penalty would "not likely" be imposed for failure to use data that were not available to the taxpayer. I would argue that the guidelines do not require taxpayers to spend large sums to gain access to private databases that are not otherwise available to them.

This example, along with the CRA's use of the expression "all reasonable efforts" [rather than “reasonable efforts”] and other differences noted above, demonstrates how the CRA guidance perhaps inadvertently imposes a higher threshold for the avoidance of a transfer-pricing penalty than Parliament intended….

Questionable TPM-09 Guidelines (p. 32:14)

The TPM states that the TPRC may take into consideration whether the taxpayer provided all of the items requested under section 231.6 or 231.2…

It is difficult to understand how the compliance or non-compliance of a taxpayer with requirements issued long after transfer-pricing documents were prepared could possibly have any relevance to the reasonable efforts inquiry under subsection 247(3). …

[F]rom informal discussions with CRA personnel, it appears that the TPRC will consider a large adjustment to constitute almost presumptive evidence of non-compliance with subsection 247(3)….

Inappropriateness of penalties where s. 247(2)(d) recharacterization (p. 32:16)

[I] do not believe that transfer-pricing penalties should be imposed merely because recharacterization has been invoked. More importantly, I think it is contrary to the Act for the CRA to conclude otherwise. As I read the words of subsections 247(3) and (4), a penalty can arise only in respect of failure to document the transactions that were actually carried out by taxpayers. The CRA itself admits that paragraphs 247(2)(b) and (d) do not in fact recharacterize the transactions in question. Paragraph 247(2)(d) merely permits the determination of "amounts" based on a different hypothetical transaction, without deeming that transaction to have taken place or to have replaced the actual one. In contrast, the penalty provisions in subsections 247(3) and (4) are entirely based on the transactions actually undertaken by taxpayers. Assuming that the taxpayer has made reasonable efforts to determine and use an arm’s length price or allocation in respect of those actual transactions, subsection 247(3) should not apply.

Appropriateness of avoiding penalties where reliance on expert reports (p. 32:18)

[In DHL Corporation and Subsidiaries v CIR, 285 F. 3d 1210 (9th Cir. 2002); aff'g, in part, rev'g, in part, and remanding 76 TCM 1122 (1998)] the taxpayer ("DHL") hired Bain & Co., Inc. ("Bain") a well known global management consulting firm, to conduct a valuation. The US Tax Court held that it was not reasonable for DHL to rely on that valuation because DHL worked with Bain to arrive at its desired value, and the court imposed a penalty on the taxpayer as a result. The Court of Appeals, Ninth Circuit, reversed the penalty, stating that Bain was a "respected financial firm" and that "[t]here is no evidence that DHL manipulated Bain's appraisal or that Bain blindly affirmed DHL's desired figure.

Dictionary meaning of “reasonable efforts” (p. 236)

On the basis of these definitions, we believe that the ordinary meaning of "reasonable efforts" is "sensible, moderate, yet determined attempts."…

Context of s. 247(3) (pp. 236-7)

As a contextual matter, subsection 247(3) was enacted as part of the 1995-1997 technical bill that added section 247 to the Act—which, as we have noted, was intended to harmonize Canada's, transfer-pricing rules with the arm's-length standard described in the 1995 OECD guidelines….

Subsection 247(3) and all related rules in section 246, including subsection 247(2), should also be viewed in the context of a taxpayer's liability under section 151 to "estimate the amount of tax payable" when the taxpayer files its tax return….[T]his statutory context suggests that in interpreting "reasonable efforts," one should emphasize the "sensible" and "moderate" aspects of the ordinary meaning of "reasonable."

1997 budget and 1995 OECD guidelines referenced therein (pp. 238-9)

The [1997] budget plan indicates that the 1995 OECD guidelines provided the inspiration for the changes to the transfer-pricing rules, including the penalty provisions….

[C]hapter 5 [of the OECD Guidelines] provides that

[t]axpayers should make reasonable efforts at the time transfer pricing is established to determine whether the transfer pricing is appropriate for tax purposes in accordance with the arm's length principle. . . . [The] extensiveness of this process should be determined in accordance with the same prudent business management principles that would govern the process of evaluating a business of a similar level of complexity and importance. [fn 31: … 1995 OECD guidelines, at paragraph 5.28 (emphasis added). …

the need for the documents should be balanced by the costs and administrative burdens, particularly where this process suggests the creation of documents that would not otherwise be prepared or referred to in the absence of tax considerations.

CRA position on reasonable efforts (p. 241)

[T]PM-09 also states:

A reasonable effort means the degree of effort that an independent and competent person engaged in the same line of business or endeavour would exercise under similar circumstances. What is reasonable is based on what a reasonable business person in the taxpayer's circumstances would do, having regard to the complexity and importance of the transfer pricing issues that arise in the taxpayer's case. …

[R]egardless, we have seen the CRA assert penalties in circumstances where it ought to be uncontroversial that reasonable efforts were made.

Conclusion (p. 243)

Application of the textual, contextual, and purposive approach to statutory interpretation mandated by the Supreme Court of Canada supports the conclusion that Parliament intended the phrase "reasonable efforts" in subsection 247(3) to require a determination of whether a taxpayer attempted to establish an arm-length price as a prudent business person would do in the same circumstances….

Standalone report not required/may be no assumptions and policies (p. 232)

[T]he statute does not require that the taxpayer condense all of the information in a single standalone document or report. Instead, the rule only requires the taxpayer to make or obtain, by the relevant time, records or documents that contain the prescribed information….

[B]y employing the phrase "if any," the rule expressly contemplates situations where no assumptions, strategies, and policies exist as well as circumstances in which assumptions, strategies, and policies have no effect on the transfer price….

Narrowness of (active business) requirement of s. 247(5.1) (p. 2)

The proposed subsection 247(7.1) relief from transfer pricing requirements will, of course, be very helpful in many foreign affiliate financings guaranteed by the Canadian parent company. However, the "active business" conditions of subsection 17(8) are strict and not always possible to satisfy. For instance, a foreign affiliate borrowing used to pay a dividend would not qualify for the relief nor would a loan used to refinance a prior borrowing not directly traceable to a qualifying purpose (e.g., a prior borrowing incurred by the foreign affiliate before it was acquired by the Canadian parent, when the Canadian rules were not relevant to it).

Lack of neutrality compared to on-loan structure (pp. 2-3)

If the Canadian transfer pricing rules insist on payment of a guarantee fee where the borrowing is made directly by the foreign affiliate with credit support from the parent, the Canadian parent would suffer an additional income inclusion that would not be incurred if the borrowing were made in Canada and advanced to the foreign affiliate. In many cases, the guarantee fee requirement would lead the Canadian parent to prefer a borrowing in Canada followed by an advance to the foreign affiliate. In this way, the constrained scope of the exemption in subsection 247(7.1) leads to a distortion, or non-neutrality, in the financing decision and may discourage borrowings in the foreign country in favour of borrowings in Canada.

Protection of Canadian tax base even where no-fee guarantee for debt of CFA earning FAP (p.3)

After providing an example to illustrate this point, Geoff stated:

In other words, with the Canadian parent guarantee of a controlled foreign affiliate borrowing to earn FAPI, the corporate group as a whole is economically better off by virtue of the interest rate savings, and these savings are captured in the Canadian tax base with or without payment of a guarantee fee to the Canadian parent. Accordingly, it is not clear why the relief in subsection 247(7.1) should be constrained so as to effectively force the payment of a guarantee fee when the borrowed funds are not deployed in an active business.

CRA's position in GE cases is favourable where the parent is Canadian rather that U.S. (p.4)

The significance of these General Electric cases is that throughout this period, and despite losses at the Tax Court of Canada and the Federal Court of Appeal, the CRA has continued to aggressively assert its position that the US parent guarantee of the debt of the Canadian subsidiaries had at most nominal value, because the Canadian subsidiaries already benefited in any event from the implicit guarantees of the US parent.

In light of the CRA's consistently advanced position with respect to the negligible or nil value of parent guarantees, it would be inconsistent for the CRA to assert transfer pricing adjustments or penalties where there is no contemporaneous documentation, against any Canadian parent corporation that has guaranteed the debt of its foreign affiliate, even if the guarantee is outside the scope of the exemption in proposed subsection 247(7.1).

Appeals Branch will not review s. 247(10) downward adjustments (p. 287)

[N]o one in CRA Appeals has delegated authority under subsection 247(10), and this problematic….

In practice … we have found that CRA Appeals takes the position that the Appeals Branch has no authority to review a denied downward adjustment, and considers a notice of objection in which a denied downward adjustment is the only issue in dispute to be invalid. As a result, taxpayers will typically find that they must go to court in order to have their request for a downward transfer-pricing adjustment resolved.

CRA will decline a downward adjustment request following an upward foreign adjustment (p. 290)

According to IC 87-2R, the first circumstance in which the CRA may deny a downward adjustment request occurs where the taxpayer is able to obtain relief under the mutual agreement procedure (MAP) of an applicable tax treaty….The CRA has declined a request for a downward adjustment that was initiated by a Canadian taxpayer where the corollary adjustment requested by the taxpayer's US subsidiary led to the US subsidiary being reassessed first. The CRA denied the request on the basis that the adjustment request was the result of the actions of another tax authority.

Quaere whether s. 247(11) accords the TCC jurisdiction to hear an appeal of a s. 247(10) downward adjustment (p. 288)

[I]f subsection 247(10) is accepted as an exercise in ministerial discretion, one would expect that the appropriate forum in which to challenge the minister's decision is the Federal Court, by way of an application for judicial review of the decision. However, subsection 247(11) incorporates certain provisions of division I (including the provisions dealing with the minister's power to assess and reassess, as well as the objection provisions) and all of division J (dealing with appeals to the Tax Court and the Federal Court of Appeal) into part XVI.1 (the transfer-pricing provisions) "with such modifications as the circumstances require." Consequently, it is arguable that the Tax Court's jurisdiction to hear an appeal from a denied downward adjustment flows from subsection 247(11), since the denial is pursuant to a provision found in part XVI.1.

Quaere whether s. 247(11) gives the TCC rather than FC authority to review s. 247(10) downward adjustment (pp. 295-296)

The analysis in JP Morgan highlights the crux of the issue with downward adjustments: Subsection 247(10) of the ITA allows the minister to exercise his or her discretion to deny a downward adjustment and therefore suggests that review of the denial is within the Federal Court's jurisdiction; but subsection 247(11) mandates that certain sections, including sections 165 and 169, apply to part XVI.1 with such modifications as the circumstances require, suggesting that appeals in respect of subsection 247(10) can lie to the Tax Court. Furthermore, the decision to deny the J downward adjustment affects the computation of the taxpayer's income and tax liability, which are matters within the purview of the Tax Court….

Quaere whether TCC could accept a denial letter as an appealable assessment (p. 297)

The express incorporation of subsection 247(11) by Parliament suggests that an appeal dealing with any provision in part XVI.1 of the ITA can be made to the Tax Court, at least in those circumstances in which there is a notice of assessment to which the taxpayer can validly object Where there is no assessment to which the taxpayer can object, it is questionable whether subsection 247(11) permits the taxpayer to treat the letter denying the downward adjustment as tantamount to a notice of assessment to which the taxpayer can object or appeal. In other words, it is questionable whether the courts would accept a modification to sections 165 and 169, as they apply for the purposes of part XVI.1, to include a reference to the minister's communication of a denied downward adjustment.

S. 247(10) downward adjustment denial is appealable to TCC if embedded in s. 247(2) assessment (pp. 299-300)

[W]here the CRA undertakes an adjustment pursuant to subsection 247(2) of the ITA and, in so doing, denies a downward adjustment request under subsection 247(10), the assessment issued will be valid and binding, and the only way in which the taxpayer may have it varied or vacated is through the objection and appeals process, as was held by the Federal Court of Appeal in Optical Recording v. Canada…. .

… The difficulty with solely relying on section 12 of the TCC Act,…is that there are situations…in which a downward adjustment is denied but there is no assessment to which the taxpayer has the statutory right to object under section 165 of the ITA.

TCC to apply correctness standard to quantum and reasonableness standard to decision to make a s. 247(10) downward adjustment

[G]iven that the Tax Court, like the Exchequer Court before it, has the exclusive jurisdiction to hear appeals on matters that arise under the ITA when appeals to the Tax Court are provided for in the ITA, the Tax Court should have, under subsection 247(11), the jurisdiction to review the exercise of the minister's discretion under subsection 247(10), at least in circumstances where the taxpayer can appeal an assessment that reflects the minister's decision. If a taxpayer can appeal to the Tax Court a decision of the minister under subsection 247(10), the Tax Court must adhere to principles of administrative law when reviewing the exercise of the minister's discretion and apply the appropriate standard of review… . Accordingly, in reviewing a denied downward adjustment request, the Tax Court could review the decision to ensure both that the amount of the downward adjustment request by the taxpayer is correct and that the minister has exercised his or her discretion appropriately (that is, the minister's decision-making process contains a rational justification that is transparent and intelligible, and the decision itself falls within a range of possible, acceptable outcomes that are defensible in respect of the facts and the law).

[I]n our view, it is not appropriate that the Tax Court have jurisdiction in some circumstances (where the denied downward adjustment is reflected in an assessment to which he taxpayer has filed a notice of objection) but not in others (where the denial does not result in an assessment.) ….

Advisability of a protective appeal to FC where s. 247(10) downward adjustment (p. 308)

[E]ven in those situations in which it appears that the taxpayer can object to and appeal an assessment that does not include a requested downward adjustment, until the courts have pronounced themselves on the matter, it would be prudent for the taxpayer to file an application for judicial review in the Federal Court within 30 days of the decision and request that the application be stayed while the taxpayer appeals the assessment to the Tax Court… .

Where Canco pays an excessive amount to a Forper [namely, a particular non-resident person] that is a non-resident sister corporation in the same corporate group, subsection 247(12) makes it clear that the deemed dividend is paid to Forper, even if it is not a shareholder of Canco. This raises the problem that the deemed dividend may be subject to a full 25% withholding tax with no treaty reduction, because Forper may not reside in a treaty country even if its parent corporation does, or Forper may not be eligible for a reduction under its treaty as it may not be actually a shareholder of Canco or may not have a high enough percentage of shares to qualify for treaty benefits. Furthermore, it may be difficult to assert that any non-resident, even if it otherwise had sufficient shareholdings to qualify for treaty benefits, is the "beneficial owner" of a deemed dividend or meets and LOB clause in the treaty.

It is not clear why the reduction is only for the amount that the Minister considers appropriate....The Joint Committee recommended that the reduction be on a dollar-for-dollar basis with the repatriated amount. That recommendation was not accepted. Accordingly, one can expect to see applications for judicial review in the Federal Court if the Minister attempts to tax a dividend that is not reduced by the full amount repatriated.