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).