The Tax Court of Canada decided in favor of the taxpayer in AgraCity Ltd. v. The Queen (2020 TCC 91), marking one of only a handful of transfer pricing judgments in the modern history of Canadian transfer pricing, i.e., since Section 247 of the Income Tax Act (ITA) received Royal Assent in 1998. The Crown did not appeal the decision.
Part 1 of this article summarized the background of the case and the court’s ruling and discussed the first two key takeaways—(1) what the decision means for sham/window dressing arguments by the Canada Revenue Agency in transfer pricing cases, and (2) that the transaction should be recharacterized pursuant to to 247(2)(b)/(d). Part 2 considers the following key takeaways:
3. Repricing pursuant to 247(2)(a)/(c)
4. Functional Analysis
5. Asset and Risk Analysis Legal Form and Contracts;
6. Transactional Net Margin Method (TNMM) and Benchmarking; and
7. Burden of Proof
Key takeaway #3 – Repricing pursuant to 247(2)(a)/(c)
The court was left with determining what amount, less than all and greater than none, of NewAgCo Barbados’ net sales profits would have been payable by NewAgCo Barbados for the services provided by AgraCity had they been dealing at arm’s-length. This was the conventional transfer pricing question, the question of pricing the actual transaction that had been entered into.
There exists an important nuance between paragraphs 247(2)(a)/(c) and 247(2)(b)/(d) that bears remembering.
The terms and conditions subject to review under paragraphs (a)/(c) are not limited to those setting out a price or cost or other amount. If paragraphs (a)/(c) apply, the quantum or nature of income amounts are redetermined on the basis of the parties’ transactions reflecting substituted notional arms’ length terms and conditions. Both (a)/(c) and (b)/(d) allow for notionally changing the terms and conditions of transactions for pricing purposes. The difference between (a)/(c) transfer pricing adjustments and (b)/(d) transfer pricing adjustments is that income amounts are redetermined as to quantum and/or nature under paragraph (c) by reference to revised terms and/or conditions of the parties’ transactions, whereas under paragraph (d) it is by reference to substituted notional transactions. Both sets of provisions, if they apply, require the redetermination of the quantum of price or cost or other amount; however, neither “permit simply reallocating profits to a taxpayer because that taxpayer would not have engaged its affiliate had that affiliate been arm’s length” (pars. 22 to 25). This implies that (b)/(d) do not allow substituting the actual transaction with nothing.
In AgraCity, the Crown had chosen not to provide the court with any evidence in support of how to determine any price, cost, or other amount, nor what to base it upon or test it against. Essentially, the Crown argued the transaction would never occur, so the “price” should equal 100% of the profits. In contrast, the taxpayer’s expert did provide supporting evidence based on a benchmarking analysis pursuant to a recognized OECD Guidelines method. The expert analysis indicated that the amount paid to AgraCity generated a return on NewAgCo Barbados’ costs that was “in the range of what somewhat comparable arm’s length parties earn.” Being the only evidence of what notional arm’s-length parties would have agreed to for the services provided by AgraCity, it served by definition as being the best evidence the court had.
The court therefore concluded that the taxpayer had met its initial onus to demolish the CRA’s assumptions, and even went far beyond making out a prima facie case (par. 107). The Crown failed to produce satisfactory evidence from its own witnesses or those of the taxpayer to prove on a balance of probabilities that its relevant assumptions, or its further allegations and positions, were correct.
In reaching its conclusions, the court touched upon multiple well-established transfer pricing conventions. Of particular interest to Canadian practitioners is the court’s approach to certain concepts described in the OECD Guidelines. Insights can be gleaned from the analysis and obiter, particularly as it relates to functional analysis, entitlement to asset and risk returns, contractual legal form, and benchmarking.
Key takeaway #4 – Functional analysis
The Crown’s expert witness’ position centered upon a “functional analysis,” an analytical construct advanced by the OECD and described in the OECD Guidelines. A functional analysis seeks to identify the economically significant activities undertaken, assets used or contributed, and risks assumed by the parties to the cross-border related party transactions subject to transfer pricing regulations. It demonstrates how value is generated by the interdependencies of the functions performed by the associated enterprises with the rest of the group and the contribution that the associated enterprises make to that value creation.
According to the OECD Guidelines, performing or exercising control over the functions that contribute most to value drivers has the biggest impact on overall value creation and, ultimately, profits. While one party may provide a large number of functions relative to that of the other party to a transaction, it is the economic significance of those functions in terms of their frequency, nature, and value to the respective parties to the transactions that is important (p. 51, par. 1.51). The OECD maintains that the functions and their significance should be viewed in light of the value drivers of the business. The process of identifying the economically relevant characteristics of the commercial or financial relations should include consideration of the capabilities of the parties, how such capabilities affect options realistically available, and whether similar capabilities are reflected in potentially comparable arm’s-length arrangements (p. 53, par. 1.53; see also AgraCity at par. 107).
The Crown’s position that “100% of the net sales profits realised from the sales should have been AgraCity’s” was based on an analysis that attributed no value to NewAgCo Barbados on the basis, essentially, of it not carrying out any of the functions required for its purported business (par. 87). In dismissing the Crown’s position, the court found that NewAgCo Barbados did actually undertake certain functions, did own certain assets, and did bear certain risks. These findings imply that certain value would be attributed to NewAgCo Barbados in the context of a functional analysis, though the court did not invoke the concept of a functional analysis explicitly.
Further, in cross examination, the Crown’s expert conceded that despite having no employees, if NewAgCo Barbados, through the actions of its duly-appointed officer (one of the owners of the business), did actually source and negotiate with an arm’s-length supplier, and did effectively have a monopoly because of the terms that were struck, then those facts would create value and that would have to be looked at in a functional analysis (pars. 42 and 97).
The court’s analysis highlights a critical point in the context of Canadian transfer pricing: assuming a duly-authorized representative acts on its behalf, an entity can be treated as having valuable functionality- even in the case of no employees and/or no day-to-day activity. The case suggests that a one-time event by a duly—authorized representative (for instance, the negotiating and signing of a supply contract) could create significant value that would be attributable to an (otherwise) shell entity for Canadian transfer pricing purposes. In its OECD Guidelines, the OECD describes a detailed framework for incorporating asset/risk considerations into the functional analysis. Use of that framework may have been helpful in this case, as it may have provided the court with a methodology to analyze certain elements further.
Key takeaway #5 – Assets / risks analysis
According to the OECD Guidelines, a functional analysis is incomplete unless the material risks assumed by each party have been identified and considered. Identifying risks goes hand in hand with identifying functions and assets and is integral to the process of identifying the commercial or financial relations between the associated enterprises and of accurately delineating the transaction or transactions (p. 52, par. 1.57). The functional analysis should also consider the type of assets used, the use of valuable intangibles and financial assets, and the nature of the assets used (p. 52, par. 1.54).
In the OECD’s framework, it must be determined whether the party assuming the risk under a contract, taking into account whether the contractual terms have been applied in the conduct of the parties, controls the risk and has the financial capacity to assume the risk (p. 68, par. 1.90). If it is established that the associated enterprise assuming the risk does not exercise control over the risk or does not have the financial capacity to assume the risk, then the risk should be allocated to the enterprise exercising control and having the financial capacity to assume the risk (p. 70, par. 1.98).
The OECD Guidelines state that risk management comprises three elements: (i) the capability to make decisions to take on, lay off, or decline a risk-bearing opportunity, together with the actual performance of that decision-making function, (ii) the capability to make decisions on whether and how to respond to the risks associated with the opportunity, together with the actual performance of that decision-making function, and (iii) the capability to mitigate risk, that is the capability to take measures that affect risk outcomes, together with the actual performance of such risk mitigation (p. 55, par. 1.61).
Control over risk involves only the first two elements of risk management, as it is not necessary for a party to perform the day-to-day mitigation. Such day-to-day mitigation may be outsourced. However, where these day-to-day mitigation activities are outsourced, control of the risk would require capability to determine the objectives of the outsourced activities, to decide to hire the provider of the risk mitigation functions, to assess whether the objectives are being adequately met, and, where necessary, to decide to adapt or terminate the contract with that provider, together with the performance of such assessment and decision-making. In accordance with this definition of control, a party requires both capability and functional performance in order to exercise control over a risk (pp. 56 and 57, par. 1.65).
In AgraCity, the court found that certain assets were owned, and certain risks were borne, by NewAgCo Barbados, including:
- The supply agreement (an intangible asset);
- Inventory and inventory risk, including transportation and warehousing risk;
- Foreign exchange risk; and
- Product liability risk.
Little in the analysis addressed the notion of “control over risks” as the OECD has most recently framed it. Specifically, little in the case addressed whether NewAgCo Barbados “exercised decision-making functions” relating to supply, inventory, foreign exchange, or product liability.
According to the OECD Guidelines, “neither a mere formalising of the outcome of decision-making in the form of, for example, meetings organized for formal approval of decisions that were made in other locations, minutes of a board meeting and signing of the documents relating to the decision, nor the setting of the policy environment relevant for the risk (see paragraph 1.76), qualifies as the exercise of a decision-making function sufficient to demonstrate control over a risk.” Further, “the legal ownership of an intangible by itself does not confer any right ultimately to retain returns derived by the MNE group from exploiting that intangible” (p. 262, par. 6.42).
The director of NewAgCo Barbados, who “exercised control” over significant U.S. ClearOut distribution business risks, was also the CEO of FNA Group, and in fact exercised much of the decision-making relating to the U.S. ClearOut venture before NewAgCo Barbados was even incorporated. However, the court did not explore how one might apply the OECD’s control framework when a single individual “exercises control” over risk on behalf of both counterparties in the case of a non-arm’s-length cross-border transaction. Further, the CEO’s brother—a duly-authorized representative of NewAgCo Barbados—was responsible for negotiating and signing of the supply contract with Albaugh. That supply contract explained much of the value that accrued to the business venture, as it created a pseudo-monopoly for FNA Group. Did NewAgCo Barbados “control” the risks relating to the supply contract, or its business operations in general, sufficiently for it to be attributed the returns associated with them? Since control over day-to-day operations and risks was (at least to some degree) outsourced to AgraCity, did NewAgCo Barbados have the capability to determine the objectives of the outsourced activities, to decide to hire the provider of the risk mitigation functions, to assess whether the objectives were being adequately met, and, where necessary, to decide to adapt or terminate the contract with that provider, together with the performance of such assessment and decision-making? Or did AgraCity and/or other FNA Group personnel actually undertake those control functions?
The case did not explore how exactly to reconcile OECD guidance as it relates to functional analysis, asset ownership, and entitlement to risk returns with the facts of the case. It did not explore how one might analyze “control over risk”, and how one might “allocate” those risks for transfer pricing purposes. It is clear, however, that Canada continues to be a jurisdiction which puts an emphasis on legal ownership and contractual form in the context of transfer pricing cases. Taxpayers are therefore cautioned when structuring cross-border arrangements involving Canada to use the OECD Guidelines only as points of reference.
Key takeaway #6 – Legal Contracts/Form
The OECD Guidelines contain a specific framework that addresses contractual form versus conduct. They provide that where a transaction has been formalized by the associated enterprises through written contractual agreements, those agreements provide the starting point for delineating the transaction between them and how the responsibilities, risks, and anticipated outcomes arising from their interaction were intended to be divided at the time of entering into the contract (p. 47, par. 1.42).
However, according to the guidelines, where the characteristics of the transaction that are economically significant are inconsistent with the written contract, the actual transaction will have to be delineated. Contractual risk assumption will have to be examined taking into account “control” over the risk and the financial capacity to assume risk. Consequently, the “allocation” of risk for transfer pricing purposes may differ from its contractual stipulation. Essentially, an OECD analysis seeks to set out the factual substance of the commercial or financial relations between the parties and accurately delineate the actual transaction, and that delineation may differ from a transaction’s written form (pp. 77 and 78, par. 1.120).
The OECD Guidelines further suggest that written contracts alone are unlikely to provide all the information necessary to undertake such an analysis. Information related (1) the functions performed, taking into account assets used and risks assumed by the contractual parties, (2) the characteristics of property transferred or services provided, (3) the economic circumstances of the parties and of the market in which the parties operate, and (4) the business strategies pursued by the parties, will be necessary (pp. 47 and 48, par. 1.43).
Unfortunately, in AgraCity the court did not explore “transaction delineation” in depth. The court respected the transactions as represented by the taxpayer because the Crown failed to provide to the court evidence to the contrary (AgraCity, par. 106). The court described the service contract between AgraCity and NewAgCo Barbados as “a valid contractual agreement setting out in very large measure what AgraCity was responsible for doing and what it in fact did, as well as how AgraCity was to be paid for performing those services.” Further, as described in the takeaway related to assets/risks analysis, the court did not analyze “control over risks” and so did not consider “allocating” risks any differently than what was stated in the written contract.
Despite the lack of commentary regarding the OECD’s approach to legal contracts and transaction form, the court did provide certain helpful notes to practitioners. Although the court indicated that “there is no requirement that … a contract or agreement be in writing,” it is clear from the case that intercompany agreements are a best practice. Contracts can be used to outline the intentions of the parties and form a clear starting point for transfer pricing analysis. It is also noteworthy that an intercompany contract does not have to be perfect. The court stated that: “there [is no] requirement that such an agreement be specifically crafted for accuracy by highly paid retained professionals even if it involves millions of dollars…. This agreement specifies the services to be provided as those that were in fact provided: promotion and the provision of administrative services related to the sale of ClearOut in Canada…”
Key takeaway #7 – Benchmarking analysis
In the evidence and testimony of Mr. Rolph, the court found that “the Taxpayer has provided credible, unchallenged, uncontested and unrefuted expert evidence based on available data that confirm[ed] the amount reported by AgraCity as its profit over the costs of its services to NewAgCo Barbados was well within the somewhat rough, but in my view acceptable, range of what an arm’s length service provider might have enjoyed in circumstances similar to what I have found to be the transactions between NewAgCo Barbados and AgraCity.”
Mr. Rolph’s analysis was based on an application of the transactional net margin method (TNMM), one of the transfer pricing methods described in the OECD Guidelines. The method compares the profits resulting from a cross-border related-party transaction to the profits recognized by independent parties engaged in similar transactions under similar circumstances. Due to widely available benchmark data, as well as the method’s ability to mitigate the effect of comparability differences, the TNMM has become the most popularly applied transfer pricing method in the context of transfer pricing documentation globally.
Surprisingly, AgraCity marks the very first Canadian transfer pricing case in which the TNMM has prevailed. Prior to AgraCity, the courts had found in favor of other methods: most notably the comparable uncontrolled price (CUP) method, which tests pricing by benchmarking prices directly (as opposed to analyzing resulting profits).
It is notable that both the Appellant’s expert witness, as well as the court itself, acknowledged the limitations of the TNMM. Mr. Rolph stated his analysis was “just a crude benchmarking analysis.” The court acknowledged the public companies relied upon in the expert analysis represented only “somewhat comparable” arm’s-length parties. Nevertheless, “being the only evidence of what notional arm’s-length parties would have agreed to for the services provided by AbraCity,” the method was accepted. The result in AgraCity should therefore give some comfort to taxpayers and practitioners when relying upon the TNMM in the context of Canadian transfer pricing.
Key takeaway #8 – Burden of Proof
The court devoted several paragraphs in its decision to reiterate the application of the concept of ‘burden of proof’ in transfer pricing cases. Specifically, it pointed to House v. The Queen. 2011 FCA 234, which established that:
- The burden of proof in taxation cases is that of the balance of probabilities.
- With regard to the assumptions on which the minister relies for his assessment, the taxpayer has the initial onus to “demolish” the assumptions.
- The taxpayer will have met his initial onus when he or she makes a prima facie case.
- Once the taxpayer has established a prima facie case, the burden then shifts to the minister, who must rebut the taxpayer’s prima facie case by proving, on a balance of probabilities, his assumptions.
- If the minister fails to adduce satisfactory evidence, the taxpayer will succeed.
It is helpful to be reminded of the onus and the shifting burden of proof, as within the tax realm transfer pricing cases tend to be those which require the greatest depth in factual analysis and the greatest number of assumptions. Transfer pricing requires a comprehensive understanding of not only the taxpayer’s business enterprise, but also that of its affiliates, that of potential benchmarks (be they transactions or other companies), and the industry as a whole. In Cameco, a notably complex case, the court devoted nearly 200 pages in its reasons for judgment to a summary of the facts (as compared to fewer than 80 pages for background, legal analysis and judgment combined). The background and facts of AgraCity were less complex, but still represented a substantial portion of the words in the judgment.
Providing comprehensive, compelling, and relevant information to the CRA during an audit should be a focus—as the burden of proof during the initial examination lies with the taxpayer. Upon commencement of a transfer pricing audit, CRA affords three months to the taxpayer to submit transfer pricing documentation to support their position as filed (per section 247(4)(c) of the ITA). Once the taxpayer’s position is reviewed, the burden of proof shifts to the CRA if a reassessment is rendered. Therefore, during an appeal, it is up to the taxpayer to “demolish” the CRA’s assumptions.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Peter Kurjanowicz is a transfer pricing partner at Grant Thornton LLP in Canada and leads the firm’s complex financial instrument pricing sub-specialty group. Mi Li is a senior analyst on the transfer pricing team.