Canadian multinational companies may want to note the implications of the recent transfer pricing case McKesson Canada Corp. v. The Queen(2013 TCC 404), in which the Tax Court of Canada (TCC) found in favour of the CRA concerning what constitutes a reasonable discount rate in a non- arm’s-length accounts receivable factoring arrangement and upheld the $27 million increase in the Canadian taxpayer’s income for its 2003 taxation year.
Although the taxpayer has appealed this decision to the Federal Court of Appeal (FCA), multinationals will be interested in the approach the TCC used in determining what it considers an acceptable arm’s length range for an accounts receivable factoring discount.
Further, the TCC’s decision to apply Canadian withholding tax on the secondary adjustment in this case is important for both Canadian taxpayers and non-residents engaged in cross-border controlled transactions.
Finally, the TCC made some interesting observations in obiter on why the courts should not be influenced by the tax morality debate currently taking place around the world in rendering judgments on transfer pricing matters.
Facts of the case
In 2002, McKesson Canada (Canco), a Canadian health care corporation, entered into a five-year Receivables Sale Agreement (RSA) to sell all eligible trade receivables to its Luxembourg parent company (Luxco). Both entities were indirect subsidiaries of a U.S. multinational.
Luxco agreed to purchase all of Canco’s eligible receivables daily as they arose for the next five years, in addition to a one-time purchase of $460 million in upfront receivables. Generally, the receivables consisted of trade receivables from arm’s-length customers not in default. The RSA provided for certain termination events, and Canco did not warrant or guarantee the collectability of the receivables or any portion thereof.
Canco sold receivables to Luxco for an amount equal to the face amount of the receivables, discounted by a factor of 2.206% for the 2003 taxation year. Canco deducted the discount as a financing charge in 2003, inclusive of the discount applied to the upfront receivables transfer.
The CRA challenged the discount rate as greater than the amount which would have been agreed between persons dealing at arm’s length. Accordingly, the CRA reduced the discount rate to 1.013%, thereby increasing Canco’s 2003 taxable income by $27 million.
The parties also entered into a Servicing Agreement, where Canco would service the receivables for a fixed annual fee of $9.6 million. The Servicing Agreement was not contested by the CRA, although it was referenced in the TCC’s reasons for judgment.
In addition, the CRA issued a consequential assessment on Canco for failure to withhold Part XIII withholding tax (i.e., a secondary adjustment). The CRA assessed Part XIII withholding tax of 5% on the disallowed amount of the original discount as, under Canadian tax law, the disallowed amount is deemed a dividend paid by Canco to Luxco.
Summary of the TCC’s decision
The TCC found in favour of the CRA that the 2.206% discount rate applied to Canco’s sale of trade accounts receivables to Luxco was in excess of what would have been agreed to by arm’s-length parties. As a result, the TCC’s Honourable Justice Patrick J. Boyle upheld the CRA’s transfer pricing reassessment that increased the taxpayer’s taxable income by approximately $27 million in 2003 (a short three-month taxation year).
In its decision,the TCC computed its own range of acceptable discount rates, using a formula generally advocated by both parties. The CRA’s proposed discount rate (1.013%) was within this range but Canco’s discount rate of 2.206%, however, fell outside the acceptable range as determined by the TCC.
The TCC also decided in favour of the CRA on the secondary matter of the taxpayer’s obligation to withhold tax on the deemed dividend, a secondary adjustment resulting from the (primary) transfer pricing adjustment to the discount rate. While Canadian domestic law contains no statute of limitations for Part XIII withholding tax, the taxpayer argued that Article 9 of the Canada-Luxembourg Income Tax Treaty (Treaty) restricted the CRA’s ability to assess withholding tax after five years from the end of the taxation year to which the adjustment relates. The TCC decided that the wording in Article 9 of the Treaty does not extend to Canadian taxpayers’ obligations to have withheld tax on a deemed dividend.
This case, the latest Canadian court decision in the realm of transfer pricing, was found in favour of the CRA even though other recent Canadian transfer pricing cases were decided in favour of the taxpayer (General Electric Capital Canada Inc. (FCA) and Alberta Printed Circuit Ltd. (TCC)). In GlaxoSmithKline Inc., the Supreme Court of Canada referred the case back to the TCC for retrial (see KPMG’s TaxNewsFlash-Canada 2012-32, “GlaxoSmithKline Inc. — Supreme Court Sends Transfer Pricing Dispute Back to Square One”).
Details of the TCC’s decision
The TCC agreed that the formula to determine the discount rate comprised three main components:
- Yield Rate (reflecting the financing aspect)
- Loss Discount (reflecting the credit risk of Canco’s customers whose receivables were covered by the RSA)
- Discount Spread (reflecting some risks associated with Canco’s customers’ increased use of rebate entitlements and prompt payment discounts).
The Yield Rate component was largely undisputed. However, the TCC applied floating terms to the Loss Discount and Discount Spread, rather than fixed terms set by Canco and Luxco in the RSA. Further, the TCC re-computed the discount rate adjustments used by Canco in the RSA (described below) to derive the Loss Discount and Discount Spread for the decision. The adjustments applied in the RSA by the taxpayer primarily increased the effective discount rate, and the TCC proposed substantially lower adjustments, as explained below.
Reasons for TCC’s discount rate
The TCC stated that a key reason for recomputing the Loss Discount and Discount Spread was to apply floating terms that may benefit both Canco and Luxco. The original terms were fixed based on several risk assumptions made when the RSA was drafted. Certain discount rate adjustments were, according to the TCC, cushioned in favour of Luxco to account for these risks assumed in the RSA. The TCC reduced some discount rate adjustments, such as the prompt-payment discount, and eliminated other adjustments, such as the accrued rebate dilutions discount. The TCC reasoned that adequate evidence was not provided to substantiate the reasonableness of certain discount rate adjustments in the RSA.
The TCC disagreed with Canco’s argument that the CRA’s determination of the discount rate was a re-characterization under the Income Tax Act. The TCC stated that its approach to determining an arm’s-length discount rate was within the normal realm of transfer pricing adjustments. The TCC suggested that the quantum of an amount can be adjusted under the transfer pricing rules of the Income Tax Act based on the terms and conditions agreed to by arm's-length parties, and these adjustments can be made to conform to the arm's-length standard without giving rise to a re-characterization of the transaction itself.
The transaction can be re-characterized when the bona fide primary purpose of the transaction was to obtain a tax benefit, and the transaction would not have been entered into between persons dealing at arm’s length, under the transfer pricing rules of the Income Tax Act.
In recomputing the discount rate components, the TCC either disregarded or significantly reduced many of the discount rate adjustments that Canco was relying on. The components were recomputed based on facts provided in evidence, a requirement of court procedure. Since the RSA fixed many elements that could increase or decrease, the TCC found it appropriate to evaluate the reasonableness of the discount rate adjustments from both parties’ perspective, so long as arm’s-length factoring arrangements are negotiated in a similar fashion.
This case is a reminder that documentation of the arm’s-length nature of the various terms and conditions of an intercompany transaction is critical to demonstrate compliance with transfer pricing rules.
Treaty limitations do not apply to withholding tax assessments
The TCC agreed with the CRA that the assessment of the Part XIII withholding obligation on Canco was not restricted by Article 9(3) of the Treaty. Article 9(3) of the Treaty provides a maximum five-year period for either country to make a transfer pricing adjustment to the taxable income of a related company residing in the other country under the circumstances described in article 9(1) of the Treaty. The TCC reasoned that Article 9 of the Treaty cannot apply to the CRA’s assessment, noting that the CRA was enforcing a collection provision in Canada’s domestic legislation on Canco, and not, per se, adjusting Luxco’s income and taxing it accordingly through Canco.
The TCC’s decision on the withholding tax issue in this case is important for both Canadian taxpayers and non-residents engaged in cross-border controlled transactions.
Many of Canada’s income tax treaties include a limitation period similar to the Canada-Luxembourg Income Tax Treaty. However, this decision if upheld on appeal may indicate that Canada’s tax treaties will not override Canada’s domestic legislation for Part XIII withholding tax assessments that are issued as secondary adjustments, albeit only where the primary transfer pricing adjustment is made within the relevant treaty time limitation.
Relevance of tax morality
Also of interest are certain obiter comments the TCC made, presumably in light of the OECD’s Base Erosion and Profit Shifting (BEPS) initiative and greater call for tax morality and transparency (for details, see KPMG’s TaxNewsFlash-Canada 2013-27, “OECD Action Plan Could Signal a Shift in the Global Tax Landscape”).
The TCC noted that the CRA did not directly or indirectly raise “any fair share or fiscal morality arguments that are currently trendy in international tax circles” and that the CRA “wisely stuck strictly to the tax fundamentals: the relevant provisions of the legislation and the evidence relevant thereto”. The TCC pointed out that questions of tax morality and fair share of taxes are within the realm of Parliament.
We can help
Your KPMG adviser can help you assess the effect of the TCC’s decision on your business, and point out ways to take advantage of any benefits arising from the decision or help mitigate its impact. For more details on this decision and its potential impact, contact your KPMG adviser.
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Information is current to January 17, 2014. The information contained in this TaxNewsFlash-Canada is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG’s National Tax Centre at 416.777.8500.
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