Canada’s Double Court System for Tax Challenges Needs Reforming

The Supreme Court of Canada noted last month that the only way to change the “complex structure” of the country’s divided jurisdiction over tax matters is through a “thoughtful, comprehensive reform that can only be achieved by Parliament.”

We agree with that assessment, particularly after a pair of rulings in June that result in ambiguity over whether Canada’s Federal Court or its Tax Court has oversight with respect to certain aspects of transfer pricing challenges.

The Federal Court reviews most actions taken by federal tribunals, while the Tax Court hears appeals from assessments under the Income Tax Act. This distinction becomes problematic when tax assessments involve discretionary decisions that are intertwined with non-discretionary elements, such as in downward transfer pricing adjustments.

Despite differences in the facts and the tax issues involved, the Supreme Court’s decisions in Dow Chemical Canada ULC v. His Majesty the King and Iris Technologies Inc. v. Attorney General of Canada dealt with the jurisdictional boundaries for tax audits and assessments.

According to the Supreme Court majority, the Tax Court determines the correctness of assessments. Its jurisdiction is generally limited to appeals of assessments, which represent the outcome of the audit process. Its role is to ascertain final tax liability rather than examine the government’s conduct during the audit. Consequently, discretionary decisions made by the government during the audit process fall outside its scope.

Decisions based on the government’s exercise of discretion are part of the audit process that the Federal Court can review on a reasonableness standard. Judicial review isn’t an avenue for challenging the amount of tax assessed, which only the Tax Court can review on a correctness standard as part of its power to hear appeals of assessments.

Complexities Remain

Dow Chemical addresses the procedural route taxpayers must take when contesting the government’s refusal to make a downward transfer pricing adjustment. The majority held that this must be pursued in Federal Court.

The decision failed to address the intricacies of “split jurisdiction”—a scenario where an appeal includes an assessment accompanied by a discretionary decision. An example is when a government reassessment causes an adjustment, under the transfer pricing rules or otherwise, that increases tax liability (an upward adjustment) but declines to make a downward transfer pricing adjustment requested by the taxpayer.

The implication of Dow Chemical is that such disputes must be pursued in both courts. However, there is ambiguity concerning the ability of either court to examine the amount of the downward adjustment, and procedural risk when there are interrelated upward and downward adjustments in the same assessment.

When a taxpayer requests a downward adjustment under Subsection 247(10) of the Income Tax Act, the first question is whether the adjustment is correct under the main transfer pricing rule in Subsection 247(2). The second question is the government’s judgment on its appropriateness in the circumstances.

Based on the legislative language, the government’s discretion involves the decision to make the downward adjustment, not the basis for or amount of the adjustment itself. Which court is reviewing this non-discretionary element of a downward transfer pricing adjustment following Dow Chemical?

The majority of the Supreme Court seems to assume there is only a discretionary decision involved. But the premise of Subsection 247(10) is that Subsection 247(2) determines if there is a downward adjustment, and the government can only assess the appropriateness of making it.

The majority addressed neither the Federal Court’s role in determining the amount, nor the Tax Court process for the appeal of an assessment involving both upward and downward adjustments or where the taxpayer and minister disagree on the amount of a downward adjustment.

The dissenters in Dow Chemical would have allowed the company to challenge the government’s decision in Tax Court. Not only is this more practical than requiring taxpayers to pursue parallel proceedings in both courts, but it also provides effective judicial oversight of the non-discretionary element of the downward adjustment.

Consider a scenario where a taxpayer identifies an error in the pricing of a transaction with a non-arm’s-length nonresident. The taxpayer requests a downward adjustment of $100. The Canada Revenue Agency agrees there was an error but determines that an adjustment of only $50 reflects an arm’s-length transfer price.

Dow Chemical seems to hold that only the Federal Court can review the government’s decision not to make the additional $50 adjustment. Does the Federal Court’s oversight extend to the non-discretionary aspect of the assessment—that is, whether the correct downward adjustment is $100 or $50, or is that a matter for the Tax Court?

Questions also arise as to how the Tax Court should handle appeals of assessments where there are both upward and downward adjustments at issue. Take, for example, a taxpayer that has paid amounts to related nonresidents under multiple, interrelated transactions, such as an amount paid for goods and another amount paid for intellectual property.

If the government reassesses on the basis that the taxpayer has overpaid for the goods (an upward adjustment) and the taxpayer argues that it must then have underpaid for the intangibles (a downward adjustment), how does the Tax Court approach the case if the government refuses to make the downward adjustment?

Outlook

The ambiguity regarding review of the amount of a downward adjustment highlights the need for reform by Parliament.

This could mean a merger of the Tax Court and Federal Court to eliminate the divided jurisdiction altogether or, more modestly, an amendment to the Income Tax Act to provide review by the Tax Court of government decisions on downward adjustments, as is the case for other discretionary decisions such as extensions of time to file objections.

Either option could ensure effective review of downward transfer pricing adjustments in the context of the taxpayer’s overall tax liability.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Amanda Heale is partner at Osler, Hoskin & Harcourt focused on tax controversy and litigation, international tax and transfer pricing.

Kaitlin Gray is an associate at Osler, Hoskin & Harcourt focused on tax controversy and international tax.

Write for Us: Author Guidelines