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Marzen: Tax Court Upholds Transfer Pricing Adjustments

The decision of the Tax Court of Canada in Marzen Artistic Aluminum Ltd. v. The Queen (2014 TCC 194) is the latest addition to a growing body of Canadian judgments on the application of the transfer pricing rules in section 247 of the Income Tax Act (Canada) (the “Act”).

In a lengthy set of reasons, the Tax Court upheld all but a fraction of the CRA’s reassessment of the taxpayer, such reassessments having disallowed the deduction of approximately $7.1M of fees paid by the Canadian taxpayer to its Barbados subsidiary. The Court also upheld the imposition of a penalty under subsection 247(3) of the Act.

The taxpayer was in the business of designing, manufacturing and selling aluminum and vinyl windows. Beginning in 1999, the taxpayer implemented what the Court referred to as the “Barbados Structure”. Under this structure, the taxpayer entered into a “Marketing and Sales Services Agreement” (“MSSA”) pursuant to which the taxpayer’s Barbados subsidiary (“SII”) would provide certain marketing and other sales-related services to the taxpayer in respect of certain jurisdictions, notably the U.S. The fee was calculated as the greater of $100,000 or 25% of sales originated by SII. In total, amounts paid by the taxpayer to SII under the MSSA and related agreements was $4.1M for 2000 and $7.8M for 2001. These amounts were deducted by the taxpayer in computing its Canadian income. SII paid nominal income tax in Barbados on this income. SII then declared dividends to the taxpayer, which were generally received tax-free as dividends out of exempt surplus, pursuant to the deduction in section 113 of the Act.

The Canada Revenue Agency reassessed under section 247 of the Act to disallow a portion of the deduction and imposed a penalty.

In considering the transfer pricing rules in section 247, the Court stated the issues were as follows: (i) whether the terms and conditions imposed in respect of the MSSA differed from what would have been agreed to by persons dealing at arm’s-length, (ii) if so, what adjustments should be made to the quantum of the fees paid under the MSSA so that it was equivalent to the price that would have been paid had the parties been at arm’s-length, and (iii) whether the taxpayer was liable to penalty under subsection 247(3) for the 2001 tax year.

The Court determined that the terms and conditions of the arrangement were not consistent with what arm’s-length parties would have agreed to. In the Court’s view, SII provided few or no marketing and sales services (such services having been subcontracted to another of the taxpayer’s foreign subsidiaries). Further, the Barbados Structure was purely tax-motivated, allowing deductible fees to be repatriated as tax-free exempt surplus dividends. These “attractive advantages” in the Court’s view, would not be available to arm’s-length parties. In the Court’s opinion, applying the “comparable uncontrolled price” method of determining the transfer price, as argued by the Crown, provided the most accurate arm’s-length price.

In this case, the taxpayer was entitled to deduct certain of the fees paid to SII plus $32,500 in each year for corporate and directorship services provided to SII by its director. In the result, the vast majority of the fees paid by the taxpayer to SII were denied and added back into the taxpayer’s income. The Court also found that the transfer pricing penalty was applicable, as the taxpayer failed to make reasonable efforts to determine and use arm’s-length transfer prices in 2001 (the 2000 adjustment did not meet the $5 million threshold for imposing a penalty under subsection 247(3) of the Act).

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Marzen: Tax Court Upholds Transfer Pricing Adjustments

Spruce Credit: Avoidance Transactions and the Duke of Westminster

In Spruce Credit Union v. The Queen (2014 FCA 143) the Federal Court of Appeal upheld the lower court’s interpretation and application of the inter-corporate dividend deduction under subsection 112(1) of the Income Tax Act (Canada) (the “Act”). The Court of Appeal also considered the interpretation of “avoidance transaction” for purposes of the general anti-avoidance rule (“GAAR”) in section 245 of the  Act.

Spruce Credit Union (“Spruce”) was a member of a network of credit unions providing financial services to individuals in British Columbia. Two separate provincially-owned entities were responsible for insuring the deposits of B.C. credit unions during the relevant period: the Credit Union Deposit Insurance Corporation (“CUDIC”) and the Stabilization Central Credit Union of British Columbia (“STAB”).

Certain regulatory changes required that funds held by STAB were to be transferred to CUDIC. After considering alternatives, it was decided that CUDIC would assess the member credit unions the amount in aggregate necessary to meet the fund requirement, and STAB would pay a dividend on its Class A shares to the credit unions, roughly equal to the assessment. In fact, two dividends were declared and paid: (a) “Dividend A”, from STAB’s “aggregate cumulative investment income”, and (b) Dividend B, from STAB’s “aggregate cumulative assessment income”.

The Canada Revenue Agency (the “CRA”) reassessed Spruce, denying the inter-corporate dividend deduction (under subsection 112(1) of the Act) in respect of Dividend B (Dividend A was not reassessed). The CRA assessed Spruce on two grounds: (a) the dividend was not deductible under ordinary rules, but rather was governed by specific rules in the Act pertaining to credit unions, and (b) the GAAR applied.

The Tax Court (2012 TCC 357) held the deduction under subsection 112(1) was available to Spruce in respect of Dividend B. Further, there was no “avoidance transaction” and therefore the GAAR could not apply. (Note: The Tax Court’s costs award in Spruce Credit (2014 TCC 42) was not considered in the present case. That decision is the subject of a separate appeal before the Federal Court of Appeal (Court File No. A-96-14).)

On appeal, the Crown argued that the Tax Court erred because it was “inappropriate to consider whether the taxpayer chose the particular transaction among alternatives primarily based on tax considerations”. In the Crown’s view, the Federal Court of Appeal’s decision in MacKay v. The Queen (2008 FCA 105) required the Court to consider whether the non-tax objective could have been obtained without the particular impugned transaction or through an alternative transaction.

In the present appeal, the Federal Court of Appeal held the lower court had made no error in respect of its findings regarding the availability of the deduction under subsection 112(1). Further, the Court of Appeal rejected the Crown’s arguments regarding the GAAR.

The Court held that when determining whether a particular transaction is an avoidance transaction, the existence of an alternative transaction that may have attracted additional tax is only one factor to consider. The very existence of such alternative transaction is not, in and of itself, determinative of whether there has been an avoidance transaction. The fact that this alternative transaction exists is only one consideration in determining whether any transaction in a series in an avoidance transaction.

The Federal Court of Appeal noted that the Crown’s suggested interpretation would undermine the long-standing Duke of Westminster principle in Canadian tax law that taxpayers are free to organize their affairs in a manner to pay the least amount of tax within the bounds of the law. The Supreme Court of Canada has affirmed the validity of the Duke of Westminster principle in numerous GAAR decisions.

It is not entirely clear what distinction may be made between the facts and reasoning in the present case and those in MacKay. In Spruce Credit, there was a regulatory regime that required compliance and which necessitated the transfer of funds from STAB to CUDIC. The taxpayers chose a tax-efficient manner in which to achieve the regulatory compliance. In MacKay, the taxpayers choose a course of tax-efficient planning based on a voluntary acquisition of certain real property. That said, in neither case is this distinction particularly clear.

Perhaps future court decisions may provide some guidance on this point and on the interpretation of “avoidance transaction” generally. At the time of publication of this article, the Crown had not yet sought leave to appeal the decision to the Supreme Court of Canada.

A longer version of this article will appear in an upcoming edition of CCH’s Tax Topics.

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Spruce Credit: Avoidance Transactions and the Duke of Westminster

Crown Appeals Tax Court Decision in Guindon – Are Advisor Penalties “Criminal”?

On October 31, 2012, the Crown filed a Notice of Appeal with the Federal Court of Appeal against the judgment of the Tax Court of Canada in Julie Guindon v. The Queen (2012 TCC 287). In that decision, the Tax Court held that the advisor penalties imposed under section 163.2 of the Income Tax Act were criminal in nature, and therefore attract constitutional protection under the Canadian Charter of Rights and Freedoms. The Court also held that the standard of “culpable conduct” in section 163.2 was a higher standard than “gross negligence” as the latter has been interpreted in the context of subsection 163(2) penalties. For a more detailed review of the Tax Court decision, see our previous post here.

In particular, the Crown has appealed the Tax Court’s finding that the Charter applies to section 163.2 penalties, and the determination of the Court that “culpable conduct” is a different standard than “gross negligence”.

The advisor, who was found to have engaged in culpable conduct (and therefore would have been subject to the assessed penalty had the court not found the penalty to be criminal in nature) has yet to file a cross-appeal on that point.

Stay tuned to www.canadiantaxlitigation.com for further updates on this important appeal.

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Crown Appeals Tax Court Decision in Guindon – Are Advisor Penalties “Criminal”?

Crime And (No) Punishment: Guindon v. The Queen

The Tax Court of Canada recently released its decision in Guindon, a case concerning the application of third-party penalties under section 163.2 of the Income Tax Act (the
“Act”). The Court found that the penalty imposed under section 163.2 of the Act is a
criminal penalty, not a civil one, and therefore subject to the same constitutional protections as other penal statutes enacted by the federal government.

Click here to read more.

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Crime And (No) Punishment: Guindon v. The Queen

Canada’s Sommerer Decision and Double Taxation

A recent decision of Canada’s Federal Court of Appeal provides insight on the application of the country’s tax treaties to income that is attributed to a Canadian resident taxpayer under the Income Tax Act (Canada). Also, the court made useful comments on the classification of an Austrian private foundation (privatstiftung) for domestic Canadian tax purposes.

In Peter Sommerer v. The Queen, 2012 FCA 207, the court affirmed the decision of the Tax Court of Canada (2011 TCC 212) finding that gains realized on dispositions of shares by an Austrian private foundation were not taxable in the hands of an individual beneficiary of the foundation on the basis that either (a) the gains could not be attributed to the Canadian individual under the ITA’s attribution rules or (b) the capital gains article of the Austria-Canada Income Tax Convention of 1976, as amended, prohibited Canada from taxing the gains.

To read the full article by Jesse Brodlieb, Matthew Peters, and Tony Schweitzer, as published in Tax Notes International, Vol. 67, Number 6, August 6, 2012, please click here. For our earlier blog post on the decision, please click here.

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Canada’s Sommerer Decision and Double Taxation

South African Tax Case Considers Application of Capital Gains Treaty Exemption to Deemed Disposition

A recent decision of the Supreme Court of Appeal of South Africa considered the application of the capital gains article in a double tax convention based on the OECD model to a deemed disposition of property occurring as a result of an “exit tax” imposed on an emigrating corporation. As the Court’s decision concerns capital gains exemption language that is similar to that used in most double tax treaties based on the OECD Model, it provides a helpful glimpse into how such provisions may be interpreted in other jurisdictions, including Canada.

In Commissioner for the South African Revenue Service v. Tradehold Ltd [2012] ZASCA 61, the Supreme Court of Appeal of South Africa (the “Court”) considered whether Article 13(4) of the Luxembourg-South Africa Tax Convention (the “Convention”) applied to exempt a deemed disposition arising under South Africa’s domestic “exit tax” from being subject to tax in South Africa.

The taxpayer, Tradehold Ltd. (“Tradehold”), was a publicly-listed holding corporation incorporated in South Africa. Under the domestic legislation, Tradehold was deemed to be a resident of South Africa by virtue of having been incorporated there. On July 2, 2002, the board of directors of Tradehold, at a meeting in Luxembourg, resolved that all further board meetings of the corporation would be held in Luxembourg. As a result, Tradehold became resident in Luxembourg under common law principles. Nonetheless, under South African legislation at the time, the corporation remained resident in South Africa.

As a dual resident corporation, the Convention’s “tie breaker” rule provided that Tradehold was deemed to be resident solely in Luxembourg for Convention purposes. A change to the definition of ‘resident’ under the South African domestic law to exclude a corporation that is “deemed to be exclusively a resident of another country for purposes of the application” of one of South Africa’s tax conventions, including the Convention, subsequently took effect on February 26, 2003.

The Commissioner assessed Tradehold on the basis that when Tradehold’s seat of effective management was relocated to Luxembourg, or when the domestic legislative change resulted in the corporation ceasing to be a deemed resident of South Africa, Tradehold was deemed to have disposed of its only relevant asset, namely, 100% of the shares of a subsidiary corporation, under South Africa’s departure tax. The result was a deemed capital gain in excess of R400,000,000.

At the Tax Court, the taxpayer argued that the deemed disposition was exempt from South African tax pursuant to Article 13(4) of the Convention, which designated the right to tax capital gains on most non-immovable property to the state of residence and not the source state. It was argued by Tradehold that the exemption was available because at the time of the deemed disposition the Convention tie breaker rule applied to deem Tradehold to be resident in Luxembourg only. The Tax Court rejected the Commissioner’s argument that the exemption in the Convention, which excluded “gains from the alienation of property” did not apply to a deemed disposition, as a deemed disposition was not an “alienation” for these purposes.

On appeal to the Supreme Court of Appeal, which is the highest court in South Africa for non-constitutional matters, the Commissioner again argued that the Convention did not provide an exemption for deemed dispositions, on the basis that a deemed disposition is not an “alienation”. The Commissioner argued that if Article 13(4) of the Convention applied, South Africa’s exit tax would be ineffective for corporations that migrate to a country with which South Africa has entered into a double tax treaty; it was argued that this could not have been the intention of the legislature. In addition, the Court considered the Commissioner’s argument that since the deeming provision in the domestic legislation provided that it applied “for purposes of this Schedule”, it could not apply to the Convention.

The Court held that the Convention modified South Africa’s domestic law and, as a result, it was necessary to determine whether the exit tax could be imposed consistently with the obligations entered into by South Africa when it signed the Convention. The Court noted that the Convention did not draw a distinction between capital gains arising from actual or deemed dispositions, despite the drafters of the Convention having been aware that the provisions of South Africa’s domestic taxing statute could result in deemed dispositions. The Court also found that there was no reason in principle why the parties to the Convention would have intended that Article 13(4) would apply only to taxes arising on actual capital gains arising from actual alienations of property. Accordingly, the Court found that the language of the Convention covered deemed dispositions and, therefore, the exit tax did not apply to Tradehold upon its ceasing to be resident in South Africa.

This decision has prompted the South African Minister of Finance, Pravin Gordhan, to state that he will consider whether legislative changes are necessary “to further clarify that a DTA does not apply to deemed or actual disposals while a taxpayer is resident in South Africa. Measures such as the immediate termination of a taxpayer’s year of assessment on the day before becoming non-resident, as is the practice in Canada, are being explored.” It is by no means clear however that the Canadian model would survive the analysis in Tradehold.

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South African Tax Case Considers Application of Capital Gains Treaty Exemption to Deemed Disposition

Public Foundation or Private Foundation? The Sheldon Inwentash and Lynn Factor Charitable Foundation v. The Queen

On February 29, 2012, the Federal Court of Appeal (“FCA”) heard oral argument in The Sheldon Inwentash and Lynn Factor Charitable Foundation v. Her Majesty the Queen (FCA Court File No. A-235-11). Pursuant to subsection 172(3) of Income Tax Act (Canada) (the “Act”), an appeal of the Minister of National Revenue’s decision to refuse charitable registration is made directly to the FCA.

The Appellant trust appealed the Canada Revenue Agency’s (the “CRA”) decision to refuse to register the Appellant as a “public foundation” within the meaning of subsection 149.1(1) of the Act. The Appellant was instead registered as a “private foundation” (For an excellent, if slightly out-of-date, discussion on the difference between private and public foundations, see Cindy Radu, “Public/Private Foundations – Issues and Planning Opportunities” in “Personal Tax Planning,” (2009), vol. 57, no. 1 Canadian Tax Journal, 119-142).

The definition of “public foundation”, as currently enacted, reads in part (underline added):

public foundation” means a charitable foundation of which,

(a) where the foundation has been registered after February 15, 1984 or designated as a charitable organization or private foundation pursuant to subsection (6.3) or to subsection 110(8.1) or (8.2) of the Income Tax Act, chapter 148 of the Revised Statutes of Canada, 1952,

(i) more than 50% of the directors, trustees, officers or like officials deal with each other and with each of the other directors, trustees, officers or officials at arm’s length, and

(ii) not more than 50% of the capital contributed or otherwise paid in to the foundation has been so contributed or otherwise paid in by one person or members of a group of such persons who do not deal with each other at arm’s length

[…]

Main Issue

The main issue on appeal is whether a trust with a single trustee can meet the “more the 50%” test in paragraph (a)(i). The basis for the CRA rejecting the Appellant’s application to register as a private foundation was that as there is only one trustee (being a registered trust company), which does not satisfy the requirement in subsection 149.1(1) of the Act that more than 50% of the directors, trustees officers or officials deal at arm’s length with each other.

The Appellant takes the position that the CRA has incorrectly interpreted the definition of public foundation. In short, the Appellant contends that the CRA is in error with respect to its position that a trust with a single trustee can never meet test in subparagraph (a)(i) of the definition.

The Appellant notes that the Interpretation Act, R.S.C. 1985, c I-21, as amended, provides that words in the plural include the singular (and words in the singular include the plural) and that Parliament could have easily drafted the legislation governing public foundations to provide for a minimum number of trustees, not dissimilar to the specified investment business and personal service business definitions which require a corporation to employ “more than five full time employees”. In the Appellant’s view, where a single, professional and arm’s length trust company is the sole trustee of a trust, the trust can still be public foundation pursuant to the definition in subsection 149.1(1), especially in light of the policy behind subparagraph (a)(ii), which the Appellant submits is to prevent the use of tax-exempt charitable donations for private gain.

The Appellant also contends that the CRA has not taken a consistent position on the application of this provision. Published CRA statements indicate that a trust requires at least three trustees in order to meet the test in subparagraph (a)(i). However, the Appellant points out that the CRA has approved as public foundations trusts with only two trustees. This position, according to the Appellant, cannot be reconciled with the CRA’s position on the “more than 50%” threshold, as two trustees by definition cannot satisfy such a requirement any more than can a trust with a single trustee.

The Crown’s position is that the definition of public foundation is clear and unequivocal, and should therefore be interpreted strictly in accordance with the Supreme Court of Canada’s decision in Placer Dome Canada Ltd. v. Ontario (Minister of Finance)[2006] SCR 715. A purposive approach, as suggested by the Appellant, cannot be used to supplant clear statutory language where there is no ambiguity.

Other Issues

The rule in subparagraph (ii) is commonly referred to as the “Contribution Test”. Pursuant to draft legislation released on July 16, 2010, the Contribution Test will be replaced by a rule whereby a foundation cannot be controlled by a person (or a group of arm’s length persons) who contributed more than 50% of the capital to the foundation (the “Control Test”). This legislation, once enacted, will have retroactive application to years after 1999.

According to the Crown’s Memorandum of Fact and Law, the CRA also refused to register the Appellant as a public foundation because, in the Crown’s view, both the Contribution Test and Control Test are not met. Interestingly, the Crown did not advance any argument on this final point in its written submissions, except to say that given the uncertainty that the proposed legislation will become law, the Appellant cannot seek registration on the grounds that it satisfies the Control Test. It is also interesting to note that the position taken by the Crown is contrary to the public position announced by the CRA by way of news release dated July 11, 2007 that it would administer the Act as though the Control Test applied.

The appeal was heard by a three-member panel of the FCA comprised of Madame Justice Eleanor Dawson, Madame Justice Johanne Trudel, and Mr. Justice David Stratas. Judgment was reserved.

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Public Foundation or Private Foundation? The Sheldon Inwentash and Lynn Factor Charitable Foundation v. The Queen

Panel of Tax Experts Debates Impact of Copthorne Decision at Canadian Tax Foundation Seminar

On Thursday, January 26, 2012, in the ballroom of the historic Fairmont Royal York Hotel in downtown Toronto, the Canadian Tax Foundation hosted a lively panel discussion on the recent Supreme Court of Canada (“SCC”) decision in Copthorne Holdings Ltd. v. The Queen. The event was also webcast, with an audience from coast to coast in Canada, and internationally as far away as France and New Zealand.

The decision in Copthorne centred on whether a “doubling-up” of paid-up capital (“PUC”) amounted to abusive tax avoidance that should be subject to the application of the general anti-avoidance rule (“GAAR”). For more on the Copthorne decision, see our previous post here.

The esteemed panel included a diverse group of tax experts. Madame Justice Karen Sharlow of the Federal Court of Appeal and Mr. Justice Wyman W. Webb of the Tax Court of Canada provided judicial insights into the potential ramifications of the SCC’s decision in Copthorne. Noted tax litigators Al Meghji of the private bar and Elizabeth Chasson of the Department of Justice considered the impact that the decision may have on the tax dispute resolution process, particularly in instances where the Canada Revenue Agency (“CRA”) is seeking to impose the GAAR. Tim Wach, a tax planner in private practice who was previously seconded to the Department of Finance, and Wayne Adams, former Director General, Income Tax Rulings at CRA rounded out the panel.

The discussion, moderated by Justin Kutyan, Pooja Samtani and Timothy Fitzsimmons of the CTF’s Young Practitioner’s group in Toronto, began with several panel members expressing their opinions on whether the decision in Copthorne changed their understanding of the application of the GAAR. Mr. Adams indicated that the SCC seems to have affirmed the CRA’s application of the GAAR where taxpayers have “created” tax attributes or have otherwise engaged in “sleight of hand”. Madame Justice Sharlow noted that the impact of Copthorne cannot be fairly assessed separate and apart from particular fact situations which will be presented to the courts in due course. Mr. Meghji said that, in his opinion, the approach taken by the Supreme Court is notably distinct from the approach taken in other international GAAR cases, particularly those coming from Australia and New Zealand.

The panel was also asked for their views on the impact of the Copthorne decision on the meaning of “series of transactions” as it is used in Canadian tax law generally. Mr. Wach expressed the view that he did not think that the decision required the Department of Finance to revise the extended meaning of “series of transactions” in subsection 248(10) of the Income Tax Act (Canada). Mr. Adams noted that, in his view, the Court validated the CRA’s approach to the concept of a “series of transactions” as it has been applied for the last 15 years (in contrast, he noted, to earlier cases in the which the SCC emphatically rejected CRA’s approach in other areas). The panel session also included a rather animated debate among the panel members on the role of the GAAR Committee in light of Copthorne and whether the positions taken by individual members of the GAAR Committee would be relevant to a Court in deciding a GAAR case.

The panel engaged in a lively discussion touching on many aspects of the Copthorne decision, the meaning of “series of transactions” and the GAAR more generally. While there was agreement among certain panel members on some issues, there was also respectful disagreement on many others with each member of the panel expressing his or her views with considerable passion and conviction.

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Panel of Tax Experts Debates Impact of Copthorne Decision at Canadian Tax Foundation Seminar