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SCC Grants Leave to Appeal in Guindon v. The Queen

The Supreme Court of Canada has granted leave to appeal in Guindon v. The Queen (Docket # 35519).  In this case, the Supreme Court of Canada will consider whether penalties imposed under section 163.2 of the Income Tax Act (Canada) constitute an “offence” within the meaning of s. 11 of the Charter.

The Tax 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.

The Federal Court of Appeal reversed the Tax Court’s ruling, first on the basis that Ms. Guindon had not followed the proper process in challenging section 163.2 by failing to provide notice of a constitutional question, and so the Tax Court lacked the jurisdiction to make the order it did. However, the Federal Court of Appeal considered the merits of the issue in any event, and held that advisor penalty proceedings are not criminal in nature and do not impose “true penal consequences.”

Our previous comments on the decisions are here and here.

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SCC Grants Leave to Appeal in Guindon v. The Queen

Supreme Court of Canada: Rectification is Alive and Well in Quebec

Earlier today, the Supreme Court of Canada delivered its decision in two Quebec rectification cases, Agence du Revenu du Quebec v. Services Environnementaux AES Inc. and Agence du Revenu du Quebec v. Jean Riopel. In a unanimous decision rendered by Mr. Justice LeBel (the only civil law judge on the panel) the Court upheld the decisions of the Quebec Court of Appeal in these two cases, permitting the parties to correct mistakes which resulted in unintended tax consequences. However, the reasons set out in Mr. Justice LeBel’s decision differ in part from the decisions of the Quebec Court of Appeal.

By way of background, Canada has a bijuridical legal system. The French civil law is the law in Quebec relating to civil matters while the law in the rest of Canada is based on the English common law. In these two cases, the issue related to whether rectification (which is a concept under the common law) can also be applied under Quebec civil law. It should be noted that the term “rectification” is not used in the reasons for judgment in either of the two appeals.

After going through the facts of each case and the decisions of the lower courts (see our previous posts on these cases here and here) Mr. Justice LeBel stated that the dispute between the taxpayers and the Quebec tax authority raises both procedural and substantive issues. He then went on to state that the substantive issue of whether proceedings to amend documents are permitted under Quebec’s civil law is the main issue and that the procedural issues are of only minor importance.

Mr. Justice LeBel noted that there was uncontested evidence establishing the nature of the taxpayers’ intention in each case and that under the civil law, in most cases a contract is based on the common intention of the parties and not on the written document. In this case, it was clear that the taxpayers’ intention was not properly documented because of the errors made by the taxpayers’ advisors. Accordingly, the taxpayers could rescind the contract or amend the documents to implement their intentions. In this case, the taxpayers had agreed to correct the documents so that the documents were consistent with their intentions.

The issue that then arises is to how such correction affects the tax authorities. Mr. Justice LeBel notes that in this case, there is an interplay of civil law and tax law and he makes the important point that the tax authorities generally do not acquire rights to have an erroneous written document continue to apply for their benefit where an error has been established and the documents are inconsistent with the taxpayer’s true intention.

Mr. Justice LeBel held that the parties in these two cases could amend the written documents because there was no dispute as to the intention of the parties and that it is open to the court to intervene to declare that the amendments to the documents made by the taxpayers were legitimate and necessary to reflect their intentions. He goes on to state that if a document includes an error, particularly one that can be attributed to an error by the taxpayer’s professional advisor, the court must, once the error is proved in accordance with the rules of evidence, note the error and ensure that it is remedied. In addition, the tax authorities do not have any acquired rights to benefit from an error made by the taxpayers in their documents after the taxpayers have corrected the error by mutual consent to reflect their intentions.

However, Mr. Justice LeBel warns taxpayers not to view this recognition of the parties’ common intention as an invitation to engage in bold tax planning on the assumption that it will always be possible for taxpayers to redo their contracts retroactively should the planning fail.

In the cases under appeal, the taxpayers amended the written documents to give effect to their common intention. This intention had clearly been established and related to obligations whose objects were determinative or determinable. Accordingly, the taxpayers’ amendments to the written documents were permitted.

Interestingly, the Attorney General of Canada, who intervened in the appeals, asked the court to consider and reject a line of authority that has developed since the Ontario Court of Appeal‘s decision in Attorney General of Canada v. Juliar, 2000 DTC 6589 (Ont. C.A.). Juliar is recognized as the leading case in rectification matters and has been the basis of numerous successful rectification applications in respect of tax matters in the common law provinces of Canada. Mr. Justice LeBel stated that the two cases under appeal are governed by Quebec civil law and it is not appropriate for the court to reconsider the common law remedy of rectification in connection with these appeals. Accordingly, Mr. Justice LeBel refrains from criticising, approving or commenting on the application of Juliar and rectification under the common law.

It is also interesting to note that in Juliar the CRA sought leave to appeal the decision of the Ontario Court of Appeal to the Supreme Court of Canada and that leave was denied. We will have to wait to see if the CRA attempts to take another case to the Supreme Court of Canada to determine the applicability of Juliar and rectification under the common law. However, it is now clear that Quebec taxpayers can now “fix” most tax mistakes if they can prove that their intention was to undertake a transaction which does not result in tax and the transaction does not involve “bold tax planning”.

Supreme Court of Canada: Rectification is Alive and Well in Quebec

Supreme Court of Canada to Release Two Decisions on Tax and Rectification

On Thursday November 28, the Supreme Court of Canada will release its decisions in the companion cases of Agence du Revenu du Québec v. Services Environnementaux AES Inc., et al. (Docket #34235) and Agence du Revenu du Québec v. Jean Riopel, et al. (Docket #34393).

The narrow question on appeal is under what circumstances the Superior Court of Quebec may correct a written instrument that does not reflect the parties’ intentions. More broadly, the issue is how and to what extent the equitable principles of rectification operate in the context of the Quebec Civil Code. These will be the first substantive decisions of the Supreme Court on tax and the doctrine of rectification.

See our previous posts on the cases here and here.

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Supreme Court of Canada to Release Two Decisions on Tax and Rectification

Waiving rights of objection and appeal: SCC declines to hear the taxpayer’s appeal in Taylor v. The Queen

On August 15, 2013, the Supreme Court of Canada dismissed the application for leave to appeal in Terry E.Taylor v. Her Majesty the Queen (2012 FCA 148).

In Taylor, the issue was whether a signed settlement agreement under which the taxpayer waived his right to appeal was binding. In that case, the taxpayer was assessed for income tax and GST, as well as gross negligence penalties and interest. He signed a settlement agreement under which the Minister of National Revenue would vacate the gross negligence penalties and, in exchange, he would waive his right to object or appeal in accordance with subsections 165(1.2) and 169(2.2) of the Income Tax Act and subsections 301(1.6) and 206.1(2) of the Excise Tax Act. The taxpayer, who did not have counsel advising him at the time, later claimed that he was under duress when he signed the agreement. Having already disposed of the penalties, he went to Tax Court to challenge the amount of tax assessed.

Justice Judith Woods held that the taxpayer’s testimony that he was “scared” and pressured into signing the agreement lacked credibility given his qualifications as a Certified Management Accountant and his extensive business and financial experience. He had ample time to consult with counsel prior to meeting with the CRA. The Tax Court held that the settlement agreement was “freely made” and signed without “undue pressure.”  The Tax Court dismissed the taxpayer’s appeal (2010 TCC 246) and the Federal Court of Appeal affirmed at 2012 FCA 148. As noted above, the Supreme Court of Canada has declined to hear Mr. Taylor’s appeal.

Taylor adds to an existing body of case law on the question of whether, and under what circumstances, settlement agreements between taxpayers and the CRA can be set aside. The Tax Court has held that in certain limited circumstances a settlement agreement may not be binding. For example, in 1390758 Ontario Corporation v. The Queen (2010 TCC 572) and Huppe v. the Queen (2010 TCC 644), agreements were held to be binding so long as they were made on a “principled” basis (see, for example, Daniel Sandler and Colin Campbell, “Catch-22: A Principled Basis for the Settlement of Tax Appeals“, Canadian Tax Journal (2009), Vol. 57, No. 4, 762-86).

Given that a significant portion of tax disputes are settled and never reach the courtroom, professional advisors should ensure that taxpayers understand the implications of signing settlement agreements under which they relinquish rights of objection or appeal.

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Waiving rights of objection and appeal: SCC declines to hear the taxpayer’s appeal in Taylor v. The Queen

The Latest Word from the Supreme Court of Canada on Conflicts of Interest: Canadian National Railway Co. v. McKercher LLP

The Supreme Court of Canada shed a bit more light on the “bright line rule” for determining when a conflict exists when a law firm represents clients whose interests are adverse in the recent decision of Canadian National Railway Co. v. McKercher LLP, 2013 SCC 39. The Court also provided further clarification regarding a law firm’s duty of loyalty to its clients and guidance for determining the appropriate remedy where this duty is breached.

In McKercher, Gordon Wallace hired McKercher LLP to act for him as the representative plaintiff in a proposed $1.75 billion class action against Canadian National Railway (CN) and others for allegedly overcharging western farmers to transport grain. At the time McKercher was retained by Mr. Wallace, the firm was acting for CN on several unrelated matters. McKercher did not tell CN in advance that it was entering into a retainer with Mr. Wallace, and after entering into this new retainer, the firm withdrew as counsel on some of CN’s matters. CN learned that McKercher was acting for Mr. Wallace in the proposed class action when it received a copy of the Statement of Claim, at which point CN terminated its relationship with McKercher and applied to disqualify the firm from representing Mr. Wallace. The Court of Queen’s Bench of Saskatchewan ruled in CN’s favour and disqualified McKercher from acting in the class action. However, the Court of Appeal overturned the disqualification and allowed McKercher to continue acting for Mr. Wallace, and CN appealed to the Supreme Court of Canada.

The Supreme Court allowed CN’s appeal, finding that McKercher breached its duty of loyalty owed to CN by breaching its duties (1) to avoid conflicts of interest, (2) of candour, and (3) of commitment to its client’s cause, which the Court described as the three salient aspects of the duty of loyalty.

In considering whether a conflict of interest existed, the Supreme Court applied the bright-line rule and found that McKercher clearly crossed the bright line by accepting the retainer with Mr. Wallace without CN’s consent. The Court upheld a strict interpretation of the rule, which stipulates that a law firm cannot concurrently represent clients whose interests are adverse without first obtaining their consent, even if the matters are unrelated.

Despite expressly rejecting arguments for a less strict interpretation of the rule, the Supreme Court pointed out that the scope of the rule is not unlimited. The Court clarified that the bright-line rule:

  1. only applies where the clients’ immediate interests are directly adverse in the legal matters the firm is representing them on;
  2. only applies to legal interests, not to commercial or strategic interests;
  3. cannot be used tactically; and
  4. does not apply where it would be unreasonable for a client to expect that the firm would not act against it in an unrelated matter (for example, with professional litigants, whose consent can be inferred when the conflicting matters are unrelated and there is no risk of improper use of confidential information).

When the bright-line rule does not apply, the Court endorsed a more contextual approach and stated that the test for determining whether a conflict of interest exists is whether there is a substantial risk that the lawyer’s representation of the client would be materially or adversely affected.

The Supreme Court observed that disqualification is normally the appropriate remedy for a breach of the bright-line rule in order to:

  1. avoid misuse of confidential information;
  2. avoid impaired representation; and
  3. maintain confidence in the administration of justice.

However, the Supreme Court noted that disqualification may not always be warranted where there is no risk of misuse of confidential information or prejudice to the complaining party. In cases where disqualification is sought only to maintain confidence in the justice system, courts must consider factors that may weigh against disqualification, including:

  • conduct that could disentitle the complaining party from seeking disqualification (such as delay in applying for disqualification);
  • significant prejudice to the non-complaining client in retaining its choice of, or any, counsel;
  • a law firm’s having accepted the conflicting matter in good faith and with the belief that the concurrent representation would not breach the bright-line rule.

The Court found that McKercher did not have confidential information that could prejudice CN in the class action. Therefore, the only relevant ground for disqualification in this case is to maintain public confidence in the administration of justice, which requires consideration of the above factors. As a result, the McKercher case has been returned to the Court of Queen’s Bench to determine the appropriate remedy for CN in light of the Supreme Court’s reasons.

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The Latest Word from the Supreme Court of Canada on Conflicts of Interest: Canadian National Railway Co. v. McKercher LLP

Daishowa-Marubeni: A Tree Fell in the Forest and the SCC Caught it!

In Daishowa-Marubeni International Ltd. v. The Queen, 2013 SCC 29, Justice Rothstein marries tax philosophy and tax practice by asking and answering the question:

If a tree falls in the forest and you are not around to replant it, how does it affect your taxes?

The Court analyzes the difference for tax purposes between liabilities and embedded obligations, considers the law of contingent liabilities, the role of tax symmetry in the Income Tax Act (Canada) (the “Act”), the role of the agreement between the parties and the role of accounting treatment in reaching the conclusion that embedded obligations are not liabilities that form part of proceeds of disposition.

For a full analysis of the decision, click here.

Daishowa-Marubeni: A Tree Fell in the Forest and the SCC Caught it!

Supreme Court dismisses leave application in Johnson v. The Queen

On March 21, 2013, the Supreme Court of Canada dismissed (with costs) the application for leave to appeal in the case of Donna M. Johnson v. Her Majesty The Queen.

The issue in Johnson was the tax treatment of receipts from a Ponzi scheme. The Tax Court (2011 TCC 540) allowed the taxpayer’s appeal and held that the receipts were not income from a source for the purpose of paragraph 3(a) of the Income Tax Act. The Federal Court of Appeal (2012 FCA 253) reversed the lower court’s decision, allowing the Crown’s appeal.

I commented on the decisions of the Tax Court and the Federal Court of Appeal in the March 2013 Ontario Bar Association Tax Section newsletter.

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Supreme Court dismisses leave application in Johnson v. The Queen

Supreme Court of Canada Considers Two Quebec Rectification Cases

In what circumstances may the Superior Court of Quebec correct a written instrument that does not reflect the parties’ intent?  That is the question that was considered by the Supreme Court of Canada on November 8, 2012 on appeals from decisions of the Quebec Court of Appeal in Agence du Revenu du Québec (formerly the Deputy Minister of Revenue of Quebec) v. Services Environnementaux AES Inc., et al. and Agence du Revenu du Québec v. Jean Riopel, et al.

The panel consisted of McLachlin C.J. and LeBel, Fish, Abella, Rothstein, Cromwell and Karakatsanis JJ. The Court reserved judgment in both cases.

Services environnementaux AES Inc.

Centre technologique AES Inc. (“Centre”) was a wholly-owned subsidiary of Services environnementaux AES Inc. (“AES”). In the context of a corporate reorganization, AES decided to sell 25% of its shares in Centre to a new investor. AES and Centre instructed their advisors that there was to be an exchange of shares under section 86 of the Income Tax Act (“ITA”) and the corresponding provisions of the provincial legislation.

AES believed – mistakenly – that the adjusted cost base of its shares in Centre was $1,217,029. Based on that error, a promissory note of $ 1,217,028 was received by AES as part of the consideration for its shares.

Subsequently, AES received a Notice of Reassessment that added a taxable capital gain of $840,770 to its taxable income. The parties discovered that the adjusted cost base of the shares had been miscalculated and that it was, in fact, only $96,001.

AES filed an application in the Superior Court of Quebec for an order rectifying the written instruments for the transactions. The Superior Court granted the application, noting that its judgment was effective as of the date of the transactions and that it was enforceable against third parties (including tax authorities). The Court of Appeal dismissed the appeal of the Quebec Revenue Agency (QRA).

Riopel

The Riopel case is another case about a corporate reorganization gone wrong.

Mr. Riopel was the sole shareholder of a corporation and held a 60% stake in a second corporation. Ms. Archambeault, Mr. Riopel’s wife, held the remaining 40% of the shares in the second corporation. The parties intended to amalgamate the corporations, with Mr. Riopel as the sole remaining shareholder of the amalgamated corporation. Both shareholders met with a tax advisor and agreed on plan for the reorganization. The parties were clear that the reorganization was to be completed with no immediate tax impact.

However, the Articles of Amalgamation included an error (i.e., the Articles did not reflect the correct share ownership). The shareholders’ professional advisors realized the error, and they tried to correct the situation without notifying the taxpayers.

Subsequently, Ms. Archambeault received a Notice of Reassessment adding a deemed dividend of $335,000 to her taxable income. The shareholders and the corporation brought an application in the Superior Court of Quebec to rectify the written instruments to accord with their true intention (i.e., implementing a reorganization without immediate tax effect).

The Superior Court denied the rectification on the basis that the agreement between the parties was distinct from the mandate given to their advisors. The Court suggested that the error could have vitiated the agreement, but it was not the remedy sought by the parties. The Court added that the error affected both the form and substance of the transactions. Accordingly, rectification was not an appropriate remedy.

That decision was reversed by the Court of Appeal of Quebec. The Court of Appeal applied the reasoning in AES and ordered the rectification so as to give effect to the parties’ common intention.

Position of the Tax Authorities in the Supreme Court of Canada (Oral Argument)

In the Supreme Court, counsel for QRA argued that the rectifications obtained by the taxpayers were not an exercise of interpretation of contracts as permitted by the Civil Code of Quebec (“CCQ”). The contracts in question were clear and should not have been modified, even though the transactions had unintended tax consequences for the parties.

Indeed, tax considerations may be the motivation behind a transaction, but they do not reflect the intent of the parties and are therefore not part of the “scope of the contract”. Thus, according to counsel for QRA, the Court of Appeal erred in rectifying the written instruments in order to make them consistent with the parties’ tax motivations. The parties could have sought cancellation of the contracts, but they failed to do so.

Justice LeBel asked if there was a legal principle that would operate to prevent parties from varying or rescinding a contract. Counsel for QRA responded that there was none, but that such a variation or rescission cannot have retroactive effect with respect to third parties. The situation would be different if the contract was cancelled by the Court since the contract is then deemed to never have existed. In such a case, the QRA would respect the decision of the Court and would assess the taxpayer accordingly.

Justice LeBel also asked if the tax authorities are third parties for the purposes of civil law. QRA’s position is that they are third parties and they have an obligation to apply the law based on the contracts concluded by the taxpayers.

Justice Fish noted that there was no dispute that the parties intended to comply with the provisions of the ITA and that, in this case, they had failed to do so because of human error. Counsel for QRA replied that the only relevant intent was in respect of the actual terms of the contract and not the tax motivation. The CCQ does not operate to vary clear contractual provisions so as to conform to the parties’ tax motivation. A possible remedy would have been the cancellation of the contracts, but that was not what the parties sought.

Counsel for the Attorney General of Canada essentially took the same position. Counsel explained that a party (or parties) cannot rewrite the history of a transaction because of unexpected tax consequences. Counsel emphasized that a distinction must be drawn between the motivation of the parties and the object of the contract. He added that the courts have long recognized that a “mistake in assumption” does not warrant the rectification of a contract. This applies in both common law and civil law.

Position of AES in the Supreme Court of Canada (Oral Argument)

Counsel argued that AES did not ask the Superior Court to modify a contract, but rather to rectify a written instrument to accord with the parties’ common intention in order to reflect the true legal relationship. In this case, the parties intended to complete the transaction in accordance with section 86 of the ITA but the written instrument did not reflect this intention. Accordingly, it was legitimate and necessary for the Superior Court to order rectification.

Justice LeBel asked about the impact of the law of evidence in the context of an application for rectification (i.e., the parol evidence rule). Counsel responded that the restrictions on presenting evidence of a party’s intent did not apply in this case since it has been admitted that the parties’ intention was not correctly reflected in the written document.

Justice LeBel also asked if it was AES’s position that a tax authority is a third party to a contract. Counsel stated that a government has an obligation to enforce tax law based on bona fide legal relationships between the parties. A tax authority would not be a third party because it would have no rights to claim with respect to the rectification of a written instrument. However, on a practical level, it may be appropriate to give the tax authorities an opportunity to be heard.

In closing, counsel stated that an application for rectification in Quebec is based solely on the principles of civil law and that it is not an attempt to “import” a common law concept.

Position of Riopel in the Supreme Court of Canada (Oral Argument)

Counsel stated that this was not a tax case but rather a civil law case. The question that must be asked was the following: Where can the contract be found? It is a mistake to confuse the contract with the written document evidencing it.

The Court of Appeal relied on Article 1425 of the CCQ to grant the application for rectification. Indeed, the application met the three criteria developed by the Court of Appeal in AES (i.e., necessity, legitimacy and no harm to third parties). Moreover, even if the tax authorities should be regarded as third parties, they would not be prejudiced because the rectification had no impact on the tax base.

Justice LeBel noted that numerous errors had been committed. Counsel responded that the errors all had a common origin, namely the Articles of Amalgamation. The number of written instruments to be rectified was not relevant, as long as the purpose was to give effect to the parties’ true intention.

Justice LeBel also wondered if this was an exercise of contractual interpretation. Counsel responded that granting rectification is an operation of correction following the interpretation of the parties’ true intention. Just because the provisions of a contract are clear does not mean that they reflect the parties’ intentions.

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As noted above, judgment was reserved in both appeals. We will report on the decisions as soon as they are released.

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Supreme Court of Canada Considers Two Quebec Rectification Cases

Two Rectification Cases from Quebec to be Heard by the Supreme Court of Canada on November 8, 2012

Two appeals will be heard tomorrow morning by the Supreme Court of Canada in rectification decisions from the Quebec courts. The first appeal is Agence du Revenu du Québec (formerly the Deputy Minister of Revenue of Quebec) v. Services Environnementaux AES Inc., et al. while the second appeal is Agence du Revenu du Québec v. Jean Riopel, et al.  In each case, the Quebec Court of Appeal agreed with the taxpayers that rectification was in order.

The Supreme Court’s summary of the first appeal may be found here.  Each factum in the first appeal may be read here.

The Supreme Court’s summary of the second appeal may be found here.  Each factum in the second appeal may be read here.

The decision of the Quebec Court of Appeal in the first appeal is here.  The decision of the Quebec Court of Appeal in the second appeal is here.

At 9:30 a.m. tomorrow, the live webcast of the hearings may be viewed here or here.  The archived webcast will be available for viewing a day or two later.

The newest member of the Supreme Court of Canada, Justice Richard Wagner, was a member of the panel of the Quebec Court of Appeal that decided the second appeal.  He will, therefore, not hear tomorrow’s appeals.  Accordingly, a maximum of seven judges will be on the panel tomorrow morning.

Postscript: At the conclusion of the hearing, the panel reserved judgment.  During the course of the hearing, highlights of argument were tweeted live @CanTaxLit

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Two Rectification Cases from Quebec to be Heard by the Supreme Court of Canada on November 8, 2012

Another Tax Court hearing ordered for GlaxoSmithKline Inc. on the first transfer pricing case to reach the Supreme Court of Canada

This morning, the Supreme Court of Canada dismissed the Crown’s appeal in The Queen v. GlaxoSmithKline Inc., the first transfer pricing case to be heard by the Supreme Court of Canada under subsection 69(2) of the Income Tax Act (Canada) (the “Act”) and ordered the parties to return to the Tax Court of Canada for the determination of the appropriate transfer price.  The Supreme Court of Canada remitted the matter to the Tax Court of Canada:

[76]   . . . to be redetermined, having regard to the effect of the Licence Agreement on the prices paid by Glaxo Canada for the supply of ranitidine from Adechsa.  The Tax Court judge should consider any new evidence the parties seek to adduce and that he may choose to allow.

The Supreme Court endorsed and elaborated on the legal test set out by the Federal Court of Appeal and rejected the test applied by the Tax Court.  However, it is important to note that subsection 69(2) has been replaced by subection 247(2) of the Act which applies in respect of taxation years and fiscal periods beginning after 1997.  The taxation years at issue in this litigation were 1990-1993.

The reasons for judgment were delivered by Justice Rothstein for a panel of seven (the other members of the panel were the Chief Justice, Justice Deschamps, Justice Abella, Justice Cromwell, Justice Moldaver and Justice Karakatsanis).

By way of background, GlaxoSmithKline Inc. (“Glaxo Canada”) purchased ranitidine, the active ingredient in the anti-ulcer medication called Zantac, from a Swiss non-arm’s length source approved by Glaxo UK (“Adechsa S.A.”) which was part of the Glaxo Group in the U.K.  It did so at a price approximately five times higher than the price at which the same ranitidine was sold in the market to Canadian generic drug manufacturers who did not have the right to manufacture or sell Zantac.

Glaxo Canada could not have gone into the market to purchase ranitidine at the price paid by the generic drug manufacturers and use that ranitidine to manufacture and sell Zantac in Canada.  It had the right to manufacture and sell Zantac in Canada under an agreement with Glaxo Group pursuant to which it was required to purchase all of its ranitidine from Adechsa S.A. at a price determined by Glaxo Group.  Glaxo Canada entered into a Licence Agreement with Glaxo Group which allowed it to manufacture and sell Zantac in Canada in consideration of a royalty payment to Glaxo Group.  Glaxo Canada was also required to purchase the raw ingredient, ranitidine, from a source approved by Glaxo Group (i.e., Adechsa S.A.) under a Supply Agreement between it and Adechsa S.A.  During the years at issue, the price of ranitidine purchased by Glaxo Canada was $1500 per kilogram while identical ranitidine was available and was purchased by generic drug manufacturers at $300 per kilogram.

The 1985 version of subsection 69(2) applicable to the years 1990-1993 reads:

(2) Where a taxpayer has paid or agreed to pay to a non-resident person with whom the taxpayer was not dealing at arm’s length as price, rental, royalty or other payment for or for the use or reproduction of any property, or as consideration for the carriage of goods or passengers or for other services, an amount greater than the amount (in this subsection referred to as “the reasonable amount”) that would have been reasonable in the circumstances if the non-resident person and the taxpayer had been dealing at arm’s length, the reasonable amount shall, for the purpose of computing the taxpayer’s income under this Part, be deemed to have been the amount that was paid or is payable therefor.

The Decision of the Tax Court of Canada

The issue before the Tax Court was whether the amount paid by the taxpayer to the non-arm’s-length party was “reasonable in the circumstances.”  The Tax Court held that (a) the “comparable uncontrolled price” (or CUP) method was the most accurate way to determine the arm’s-length price for ranitidine and (b) the appropriate comparable transactions were the purchases of ranitidine by the generic manufacturers. Subject to a relatively minor adjustment, the Tax Court dismissed the taxpayer’s appeal.

The Decision of the Federal Court of Appeal

The Federal Court of Appeal allowed the taxpayer’s appeal. The Court of Appeal held that the Tax Court had erred in its application of the “reasonable in the circumstances” test, and that it should have inquired into the circumstances that an arm’s-length purchaser in the taxpayer’s position would have considered relevant in deciding what reasonable price to pay for ranitidine. The Court of Appeal set aside the Tax Court judgment and sent the matter back to the Tax Court to be reconsidered.

The Hearing Before the Supreme Court of Canada

At the hearing, Crown counsel emphasized the fact that the only transaction under review was the purchase of ranitidine.  As counsel put it at the hearing, you don’t throw into the analysis “the whole deal.”  She argued that the only question is “what is an arm’s length price to pay for ranitidine?”  Counsel contended that one must strip away the non-arm’s length circumstance (i.e., the requirement to buy ranitidine at a price set by Glaxo Group).

(a) Questions for the Crown at the Supreme Court Hearing

Justice Abella was concerned about whether it was fair for the Crown to compare (under the CUP method) on the one hand the price paid by Glaxo Canada for ranitidine that was destined to become Zantac and, on the other hand, the price paid by generic drug manufacturers for ranitidine that was not destined to become Zantac.  Justice Abella asked counsel whether “in the circumstances” in subsection 69(2) meant that you look at the whole deal.  Counsel argued that you can’t look at the whole deal.

The Chief Justice focused on the words of 69(2) “that would have been reasonable in the circumstances” and asked Crown counsel what is to be included in “the circumstances”.  Crown counsel contended that the only relevant circumstance is the price of ranitidine paid by the generic drug manufacturers in Canada.  The Crown maintained that one cannot take into account any “non-arm’s length” circumstance (e.g., that Glaxo Canada must pay the price set by Glaxo Group) and that all non-arm’s length circumstances must be stripped out of the analysis under subsection 69(2).

During the Crown’s reply argument, Justice Cromwell described the Crown’s position as: ”Whatever the deal is, we ignore it.”  Crown counsel agreed with that characterization.

Justice Moldaver asked counsel, in light of the decision of Parliament not to use the phrase “reasonable in the circumstances” in the successor provision to subsection 69(2) (subsection 247(2) of the Act), why would the Crown ignore that language and call the whole structure of the deal “background music” and not part of the “circumstances”.

Justice Rothstein remarked that Glaxo Canada was not simply purchasing ranitidine but was purchasing ranitidine for the purpose of resale as Zantac.  If Glaxo Canada went into the market like the generics and purchased ranitidine, they would not have been able to resell it as Zantac and Zantac is their business.  He asked Crown counsel why the words “reasonable in the circumstances” exclude the way that a business plans to use the product it is purchasing.  He noted that there is a “generic market” and a “brand product” market for most drugs.  He asked why those circumstances are not relevant in determining the price someone would pay for ranitidine to be used for “brand product” sales as opposed to ranitidine for ”generic product” sale.

In answer to some of these concerns, counsel referred to paragraph 89 of the reasons for judgment of the Tax Court:

[89]     If the legislature intended that the phrase “reasonable in the circumstances” in subsection 69(2) should include all contractual terms there would be no purpose to subsection 69(2); any MNE would be able to claim that its parent company would not allow it to purchase from another supplier. No MNE would ever have its transfer prices measured against arm’s length prices, because all MNEs would allege that they could purchase only from sources approved by the parent company. The controlling corporation in a MNE would structure its relationships with its related companies, and as between its related companies, in this manner or in some similar manner. There is no question that the appellant was required to purchase Glaxo approved ranitidine. The issue is whether a person in Canada dealing at arm’s length with its supplier would have accepted the conditions and paid the price the appellant did.

Justice Deschamps observed that if the Crown is looking at a transaction with a generic company, it is not looking at the same transaction.  Crown counsel responsed by saying that the transaction at issue is a simple purchase of ranitidine and the Minister is only trying to value that one transaction.

Justice Abella asked counsel whether it is relevant to the pricing analysis that this was not just a purchase of ranitidine but a purchase of ranitidine for the purpose of being sold as Zantac.  Crown counsel maintained that this was just a purchase of ranitidine as subsection 69(2) strips out the non-arm’s length element.

Justice Rothstein asked counsel what there would be to argue if the matter were remitted back to the Tax Court.  Counsel responded that the Minister’s position would be exactly the same (the price paid by Glaxo Canada was not “the reasonable amount”) based on the evidence of what the generic drug manufacturers paid.  The Crown concluded by arguing that you simply cannot find a comparator selling Zantac without the concomitant non-arm’s length circumstances.

(b) Questions for Glaxo Canada at the Supreme Court Hearing

Justice Abella asked counsel whether there was any way of determining whether $1,500 per kilogram was the “fair market value” of the ranitidine to someone in Glaxo Canada’s position.  How do you test the “reasonableness” of the $1,500 per kilo price?  Counsel responded by saying that that wasn’t the Minister’s case.  The Minister simply assessed on the basis that Glaxo Canada paid more than the generics did and that was the only relevant comparator.  Once that theory was set aside by Federal Court of Appeal, that was the end of it.

The Chief Justice asked counsel whether it would be possible for taxpayers to avoid Part XIII tax on royalties for the use of intellectual property if no actual royalty was paid but was, instead, effectively embedded in the cost of the goods.  Counsel replied that such “unbundling” is unnecessary as other provisions deal with abusive tax avoidance such as that.  In any event, there are no such allegations in this case by the Minister (i.e., that “unbundling” is required or that inappropriate tax avoidance has taken place).

The Chief Justice wondered whether the Minister’s allegation that Glaxo Canada paid too much shifted the onus to Glaxo Canada to fully engage in the “unbundling” debate.  Counsel responded that Glaxo Canada paid $1,500 per kilogram to Adechsa S.A. for the ranitidine and paid a separate royalty to Glaxo Group for the use of intellectual property.  The Minister never argued that Glaxo Canada was obliged to do any sort of unbundling in this case.

Justice Rothstein asked counsel whether once the Federal Court of Appeal determined that the wrong test had been applied, it should have remitted the matter back to the Tax Court to determine the non-arm’s length price based on the proper legal test (i.e. taking into account the particular business circumstances around the transaction).  Counsel argued that sending the matter back to the Tax Court would turn the rules of civil litigation in general, and tax litigation in particular, on their heads.  He contended that the Tax Court cannot try a case that was never pleaded by the Crown.  The Chief Justice wondered whether the taxpayer had not discharged its burden of showing that $1,500 per kilogram was “the reasonable amount”.  Counsel responded by observing that Glaxo Canada, at trial, had demolished the basis for the Minister’s assessment and, in light of the judgment of the Federal Court of Appeal, the burden shifts to the Minister – the burden does not remain on the taxpayer to demonstrate why the price charged for the ranitidine was “the reasonable amount”.  Glaxo Canada met the case pleaded against it and the Minister has no right to start all over again in respect of the taxation years at issue.  On the pleadings as they currently stand, there is no case to go back to the Tax Court.

The Decision of the Supreme Court of Canada

In a nutshell, the Court held that the legal test applied by the Tax Court was incorrect as it ignored the Licence Agreement and the Supply Agreement which formed part of the relevant circumstances surrounding the transaction at issue.  As there had been no factual determination of the appropriate transfer price in light of the correct legal test, the Court referred the matter back to the Tax Court to determine the appropriate transfer price.

More detailed commentary will follow in the days to come but, in the meantime, here are some of the more important passages in the decision:

The role of OECD Guidelines

[20]   In the courts below and in this Court, there has been reference to the1979 Guidelines and the 1995 Guidelines (“the Guidelines”).  The Guidelines contain commentary and methodology pertaining to the issue of transfer pricing.  However, the Guidelines are not controlling as if they were a Canadian statute and the test of any set of transactions or prices ultimately must be determined according to s. 69(2) rather than any particular methodology or commentary set out in the Guidelines.

The relevant circumstances

[38]   . . . The requirement of s. 69(2) is that the price established in a non-arm’s length transfer pricing transaction is to be redetermined as if it were between parties dealing at arm’s length.  If the circumstances require, transactions other than the purchasing transactions must be taken into account to determine whether the actual price was or was not greater than the amount that would have been reasonable had the parties been dealing at arm’s length.

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[42]   Thus, according to the 1995 Guidelines, a proper application of the arm’s length principle requires that regard be had for the “economically relevant characteristics” of the arm’s length and non-arm’s length circumstances to ensure they are “sufficiently comparable”.  Where there are no related transactions or where related transactions are not relevant to the determination of the reasonableness of the price in issue, a transaction-by-transaction approach may be appropriate.  However, “economically relevant characteristics of the situations being compared” may make it necessary to consider other transactions that impact the transfer price under consideration.  In each case it is necessary to address this question by considering the relevant circumstances.

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[44]   Because s. 69(2) requires an inquiry into the price that would be reasonable in the circumstances had the non-resident supplier and the Canadian taxpayer been dealing at arm’s length, it necessarily involves consideration of all circumstances of the Canadian taxpayer relevant to the price paid to the non-resident supplier.  Such circumstances will include agreements that may confer rights and benefits in addition to the purchase of property where those agreements are linked to the purchasing agreement. The objective is to determine what an arm’s length purchaser would pay for the property and the rights and benefits together where the rights and benefits are linked to the price paid for the property.

Stripping out non-arm’s length elements

[47]   There were only two approved sources, one of which was Adechsa.  Thus, in order to avail itself of the benefits of the Licence Agreement, Glaxo Canada was required to purchase the active ingredient from one of these sources.  This requirement was not the product of the non-arm’s length relationship between Glaxo Canada and Glaxo Group or Adechsa.  Rather, it arose because Glaxo Group controlled the trademark and patent of the brand-name pharmaceutical product Glaxo Canada wished to market. An arm’s length distributor wishing to market Zantac might well be faced with the same requirement.

[48]   The effect of the link between the Licence and Supply agreements was that an entity that wished to market Zantac was subject to contractual terms affecting the price of ranitidine that generic marketers of ranitidine products were not.

[49]   As such, the rights and benefits of the Licence Agreement were contingent on Glaxo Canada entering into a Supply Agreement with suppliers to be designated by Glaxo Group.  The result of the price paid was to allocate to Glaxo Canada what Glaxo Group considered to be appropriate compensation for its secondary manufacturing and marketing function in respect of ranitidine and Zantac.

The use of generic comparators

[53]   . . . the generic comparators do not reflect the economic and business reality of Glaxo Canada and, at least without adjustment, do not indicate the price that would be reasonable in the circumstances, had Glaxo Canada and Adechsa been dealing at arm’s length.

Glaxo Canada was paying for more than just ranitidine

[51]   Thus, it appears that Glaxo Canada was paying for at least some of the rights and benefits under the Licence Agreement as part of the purchase prices for ranitidine from Adechsa.  Because the prices paid to Adechsa were set, in part, as compensation to Glaxo Group for the rights and benefits conferred on Glaxo Canada under the Licence Agreement, the Licence Agreement could not be ignored in determining the reasonable amount paid to Adechsa under s. 69(2), which applies not only to payment for goods but also to payment for services.

[52]   Considering the Licence and Supply agreements together offers a realistic picture of the profits of Glaxo Canada.  It cannot be irrelevant that Glaxo Canada’s function was primarily as a secondary manufacturer and marketer.  It did not originate new products and the intellectual property rights associated with them.  Nor did it undertake the investment and risk involved with originating new products.  Nor did it have the other risks and investment costs which Glaxo Group undertook under the Licence Agreement.  The prices paid by Glaxo Canada to Adechsa were a payment for a bundle of at least some rights and benefits under the Licence Agreement and product under the Supply Agreement.

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[59]   In addition, while, as Rip A.C.J. found, Glaxo Canada’s ranitidine and generic ranitidine are chemically equivalent and bio-equivalent, he also found that there was value in the fact that Adechsa’s ranitidine manufactured under Glaxo Group’s “good manufacturing practices” “may confer a certain degree of comfort that the good has minimal impurities and is manufactured in a responsible manner” (para. 118).  Zantac is priced higher than the generic products, presumably, at least in part, because of that “degree of comfort” that Rip A.C.J. acknowledged.

[60]   These are all features of the Licence Agreement and the requirement to purchase from a Glaxo-approved source that add value to the ranitidine that Glaxo Canada purchased from Adechsa over and above the value of generic ranitidine without these rights and benefits.  They should justify some recognition in determining what an arm’s length purchaser would be prepared to pay for the same rights and benefits conveyed with ranitidine purchased from a Glaxo Group source.  It is only after identifying the circumstances arising from the Licence Agreement that are linked to the Supply Agreement that arm’s length comparisons under any of the OECD methods or other methods may be determined.

Part XIII (withholding) tax

[57]   Although I said above that the purchase price appeared to be linked to some of the rights and benefits conferred under the Licence Agreement, I make no determination in these reasons as to whether the rights under the ranitidine patent granted to Glaxo Canada to manufacture and sell Zantac and the exclusive right to use the Zantac trademark are linked to the purchase price paid by Glaxo Canada to Adechsa.  However, arguably, if the purchase price includes compensation for intellectual property rights granted to Glaxo Canada, there would have to be consistency between that and Glaxo Canada’s position with respect to Part XIII withholding tax.  This issue was not specifically argued in this Court and may be addressed by the parties in the Tax Court and considered by the Tax Court judge when considering whether any specific rights and benefits conferred on Glaxo Canada under the Licence Agreement are linked to the price for ranitidine paid to Adechsa.

Guidelines for the Tax Court of Canada in making its redetermination

[54]   I agree with Justice Nadon that “the amount that would have been reasonable in the circumstances” if Glaxo Canada and Adechsa had been dealing at arm’s length has yet to be determined.  This will require a close examination of the terms of the Licence Agreement and the rights and benefits granted to Glaxo Canada under that Agreement.

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[61]   I would offer the following additional guidance with respect to the redetermination.  First, s. 69(2) uses the term “reasonable amount”.  This reflects the fact that, to use the words of the 1995 Guidelines, “transfer pricing is not an exact science” (para. 1.45).  It is doubtful that comparators will be identical in all material respects in almost any case.  Therefore, some leeway must be allowed in the determination of the reasonable amount.  As long as a transfer price is within what the court determines is a reasonable range, the requirements of the section should be satisfied.  If it is not, the court might select a point within a range it considers reasonable in the circumstances based on an average, median, mode, or other appropriate statistical measure, having regard to the evidence that the court found to be relevant.  I repeat for emphasis that it is highly unlikely that any comparisons will yield identical circumstances and the Tax Court judge will be required to exercise his best informed judgment in establishing a satisfactory arm’s length price.

[62]   Second, while assessment of the evidence is a matter for the trial judge, I would observe that the respective roles and functions of Glaxo Canada and the Glaxo Group should be kept in mind.  Glaxo Canada engaged in the secondary manufacturing and marketing of Zantac.  Glaxo Group is the owner of the intellectual property and provided other rights and benefits to Glaxo Canada.  Transfer pricing should not result in a misallocation of earnings that fails to take account of these different functions and the resources and risks inherent in each.  As discussed above, whether or not compensation for intellectual property rights is justified in this particular case, is a matter for determination by the Tax Court judge.

[63]   Third, prices between parties dealing at arm’s length will be established having regard to the independent interests of each party to the transaction.  That means that the interests of Glaxo Group and Glaxo Canada must both be considered.  An appropriate determination under the arm’s length test of s. 69(2) should reflect these realities.

[64]   Fourth, in this case there is some evidence that indicates that arm’s length distributors have found it in their interest to acquire ranitidine from a Glaxo Group supplier, rather than from generic sources.  This suggests that higher-than-generic transfer prices are justified and are not necessarily greater than a reasonable amount under s. 69(2).

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Another Tax Court hearing ordered for GlaxoSmithKline Inc. on the first transfer pricing case to reach the Supreme Court of Canada