Canada’s Supreme Court has dismissed the Crown’s application to appeal their loss against Cameco Corporation (“Cameco”) at the Federal Court of Appeal (“FCA”). Together with the recent win by AgraCity Ltd. (“AgraCity”), which was not appealed by the Crown, these cases preserve the view that Canada’s transfer pricing recharacterization rules can only rarely be applied to disregard cross-border transactions as structured by the parties.
Cameco and AgraCity were the first two taxpayers to challenge in court the Canada Revenue Agency’s (“CRA”) usage of the transfer pricing recharacterization provisions under paragraphs 247(2)(b) and (d) of the Income Tax Act. Both cases involved intercompany transfers of tangible goods (uranium and chemicals, respectively). Their wins could change how the CRA proceeds with other recharacterization disputes, such as those concerning cross-border hybrid debt instruments, and may ultimately lead to revisions to Canada’s income tax legislation—possibly with effect as early as April 19, 2021.
Background
On June 26, 2020, the FCA upheld the Tax Court of Canada’s (TCC) earlier decision that Cameco Corporation’s transactions with its Swiss subsidiary had been on arm’s-length terms, with no adjustments to income or tax required. Similarly, on August 27, 2020, the TCC allowed AgraCity’s appeal of reassessments made by the CRA. In each case, the Crown had argued the CRA’s audit reassessments were justified because the Canadian taxpayer’s arrangements with foreign affiliates were a sham, or alternatively that the transfer pricing recharacterization rules apply.
The Crown did not appeal the Tax Court decision re: AgraCity but submitted to the Supreme Court on October 29, 2020, an application for leave to appeal the Cameco FCA outcome. In response, Cameco submitted a memorandum of argument on December 3, 2020. On February 18, 2021, the Supreme Court announced it had dismissed the Crown’s appeal of Cameco, without disclosing the reasons.
Arguments by the Crown
The Crown’s arguments to the Supreme Court framed the Cameco dispute in the context of the OECD’s recent initiative against base erosion and profit shifting (BEPS), declaring in their memorandum’s first sentence that Canada’s policy is “to protect the Canadian tax base from erosion due to profit shifting.”
The Crown argued that Canadian transfer pricing law requires a taxpayer’s “arrangements … viewed in their totality” be the same as would have been adopted by arm’s-length parties, and that the arm’s-length standard requires a determination of whether “the transactions or series would have been comparable” (i.e., not just the pricing of the transaction). It argued that the FCA’s approach only considered pricing changes for existing transactions, and not recharacterization of the structure itself, in a way that collapsed those two purposes of Canada’s transfer pricing rules into one.
Citing the CRA’s usage of transfer pricing reassessments to increase taxable income of Canadian corporations by $11.84 billion in the past three years, the Crown argued that those adjustments would be put at risk by the FCA’s decision on Cameco, “with the effect of rendering Canada’s transfer pricing regime ineffective.”
The Crown argued that the FCA had inappropriately read down Canada’s recharacterization rules by finding that these provisions:
- Require no arm’s-length parties would enter the transaction under any terms and conditions;
- Can only be applied in exceptional circumstances; and
- Only apply when the substance of a transaction does not match its form, or the structure impedes a determination of pricing.
Overall, the Crown argued the FCA’s decision undermined Parliamentary policy and the arm’s-length standard in a way that could not be addressed through legislative change.
Arguments by Cameco
Cameco argued the original TCC case had shown the transfer pricing rules were completely satisfied and that the company’s decision to establish a non-resident trading subsidiary was consistent with Canada’s foreign affiliate scheme.
The FCA had found that the Crown’s focus on the foreign subsidiary’s profits was an application of hindsight; the foreign subsidiary’s profits were due to increases in uranium prices, which the TCC found Cameco did not know would be the case in advance. Similarly, the TCC found Cameco could not have predicted that the Canadian company would incur losses. The TCC had found that certain commercial agreements of Cameco’s foreign subsidiary had no value at the time they were entered into, and the subsidiary incurred losses in its first few years.
Cameco argued that the normal system of taxation is based on transactions actually undertaken by the taxpayer, and that recharacterization should apply only in very limited circumstances. More specifically, recharacterization requires a determination that the transaction would not have been entered into between any persons dealing with each other at arm’s length, not a subjective assessment of whether the particular taxpayer would have entered into the transaction. Also, the second requirement for recharacterization concerns the purpose of the transactions, but the TCC had found that the bulk of Cameco’s transactions were conducted for bona fide business purposes other than to avoid tax, so the taxpayer argued recharacterization could not apply to those transactions even if the first requirement had been met.
Even if the technical requirements for recharacterization had been met, Cameco argued the result would have been to substitute an alternate transaction or series of transactions. Since the Crown had not proposed any substitute transactions, but rather sought to disregard the transactions between Cameco and its foreign affiliate, Cameco argued the Crown was essentially trying to pierce the corporate veil and tax all of the affiliate’s profit in Cameco, as if the subsidiary did not exist.
The taxpayer disputed the Crown’s claim that the FCA’s decision put $11.84 billion of income adjustments at risk because that figure includes both recharacterization cases and more traditional transfer pricing adjustments to existing transactions; Cameco estimated that only two percent of the transfer pricing adjustments made by the CRA in that period actually relied on the recharacterization provisions under dispute in their case.
Implications
Cameco and AgraCity were the first two court cases to test Canada’s transfer pricing recharacterization rules, and both involved intercompany transfers of tangible goods (uranium and chemicals, respectively).
The CRA had publicly indicated, before the Supreme Court’s decision to dismiss the Cameco appeal, an intention to apply the same recharacterization rules to certain financial transactions between related parties, including the use of hybrid debt instruments. It remains to be seen how the CRA will proceed with disputes involving hybrid debt, in light of the Cameco and AgraCity decisions. Perhaps the CRA will continue to test the recharacterization provisions, arguing that certain hybrid debt transactions are of a type that would not be entered into between any arm’s-length parties.
We expect the Crown’s losses in Cameco and AgraCity may eventually lead to changes in Canada’s income tax legislation, to allow the CRA greater powers to enforce against base erosion and profit shifting. This could occur as early as April 19, 2021, which is the scheduled date for the release of Canada’s next federal budget. Canadian income tax law changes are typically applied only on a prospective basis.
In the meantime, for taxation years covered by the existing transfer pricing rules, we may see the CRA more often attempt recharacterization-type profit adjustments by relying on the repricing provisions alone. Canada’s repricing provisions allow adjustments to the terms and conditions of an existing transaction, without recharacterization; it remains to be clarified how much the terms and conditions of a given transaction could be adjusted before the transaction itself is essentially recharacterized or restructured. This has already been a point of disagreement by Canadian taxpayers in CRA audits and may become even more common in light of the Cameco and AgraCity decisions.
