Very shortly ago, the Federal Court of Appeal’s decision in The Queen v. Cameco Corporation (2020 FCA 112, delivered on June 26, 2020) was made public.
By any measure in contemporary taxation (in Canada certainly, but for the transfer pricing world globally) the decisions of both the Tax Court of Canada and the Federal Court of Appeal are, to use an often over-used description (although not in this instance), “landmark” decisions.
This is a “transfer pricing” case. In the tax law, encased in Canada in section 247 of the Income Tax Act and supported by considerable administrative practice of the Canadian tax authorities which in turn are informed and to a significant extent supported by longstanding guidance on transfer pricing published and curated by the Organisation for Economic Co-operation and Development (OECD), the reliability of the determination of a Canadian taxpayer’s income from or influenced by “transactions” with non-arm’s length parties is tested according to the expected outcomes of like-transactions that would involve arm’s length parties. The transfer pricing elements of Canada’s and other countries’ tax regimes, encapsulated in the notions of branch profit attribution in Article 7 and inter-entity income adjustments in Article 9 of the OECD’s Model Tax Convention, are reflected more or less intact in most bilateral tax treaties – notably Canada’s treaty with the United States, which includes explicit reference to transfer pricing guidance, and attempts to detect whether income arising from non-arm’s length transactions has been distorted by the capacity afforded by common control of the transacting parties to influence and change what equivalent unrestricted commercial transactions would have yielded. Transfer pricing has been, and continues to be, a main focus of the OECD work on “base erosion and profit shifting ‘” (BEPS) in the course of which the important elements of the OECD’s transfer pricing guidance (the Transfer Pricing Guidelines) has been restated to include, among other things, the notion of “accurate delineation” of transactions as a first step before applying tax law to them. “Accurate delineation” is a build out, of sorts, of an “economic substance” notion embedded in transfer pricing that often is equated with tax authorities’ entitlement to “recharacterize” taxpayers’ transactions to accord with the tax authorities’ perception of their “economic substance”, particularly when alternative legal formulations of essentially the same economic outcome give rise to dramatically different tax outcomes.
Cameco arranged its international procurement, sale and distribution of Uranium through Swiss and Luxembourg subsidiaries. There was no doubt that tax considerations were taken into account, in light of how the income of “foreign affiliates” of Canadian taxpayers is taxed under the Act, and as Cameco, the evidence showed, reacted to changes in the international market for uranium originating with an agreement between the United States and Russian governments governing how “Russia could sell uranium formerly used in its nuclear arsenal”. The Tax Court’s lengthy reasons describe in considerable detail the geopolitical, the geo-commercial, and Cameco’s transactional and organizational arrangements to participate in the resulting international market for uranium, a much briefer summary of which is the platform for the FCA’s decision. The operations of the Swiss and Luxembourg subsidiaries were supported by services provided by Canada under intercorporate services arrangements that the Tax Court found to be commercial customary within multinational enterprises and generally respected operationally by the parties in their dealings and respective business operations.
The CRA assessed Cameco to include the income earned by its relevant foreign affiliates in its income on the basis either that the Cameco group’s organizational and transaction arrangements were a “sham” or that that the transfer pricing rule(s) in section 247 of the Act justified such an outcome either, first, because the affected transactions had no arm’s length analogue for Cameco and therefore could be recast under paragraphs 247(2)(b) and (d), as the CRA imagined they should, and would have taken place had the transaction parties not been commonly controlled, and second, in any event, because the pricing of the transactions would be the kinds of transactions undertaken by arm’s length parties was nevertheless not concordant with the terms and conditions of dealings between arm’s length parties.
The Tax Court of Canada decided for the taxpayer, finding that the arrangements (i) did not constitute a “sham” and in so doing reaffirming the very high bar in Canadian tax law for reaching a “sham” determination”, (ii) did not comprise the use of transactions with no arm’s length analogue for purposive tax avoidance as the sub-rule in paragraphs 247(2)(b) and (d) contemplate, and in so finding determined that these paragraphs did not amount to a statutory permission to “recharacterize” taxpayers’ transactions, whatever overarching OECD guidance and administrative supposition might have suggested – deferring, as the Supreme Court in GlaxoSmithKline had done, to the enacted Canadian law and not propositions of guidance or administrative practice on the part of tax authorities, and (iii) apply the standards of arm’s length transfer pricing analysis in paragraphs 247(2)(a) and (c) – the “main” transfer pricing rule which the Tax Court found subsumed the outcome of any analysis if necessary under paragraphs 247(2)(b) and (d) to detect a transactional starting point for the (a) / (c) analysis when the actual transaction being evaluated lacked an arm’s length analogue (which the Tax Court said was not recharacterization, but rather a determination to support the application, then, of the main rule).
The Tax Court’s decision reconciling paragraphs 247(2)(a) and (c), on the one hand, and 247(2)(b) and (d), on the other, as complementary aspects of a coherent “whole” rule, was original and seminal in Canadian tax law, even though coming long after section 247 was introduced into the Act. The application of an evidence-based analysis to determine as a legal matter the transactions to which the tax law applied provided that the transacting parties could be shown to have respected their adopted organizational forms and transaction arrangements and the corresponding conclusion that the anti-avoidance aspect of section 247, in paragraphs 247(2)(b) and (d), does not sustain a general licence to “recharacterize”, were seminal determinations. The possible importance of this should not be underestimated. As this case has been litigated and continues to make its way through the judicial system, the Canadian tax authorities and their counterparts in other countries have entrenched the notion of “accurate delineation” of transactions (reflecting, but in the contemporary context extending a more muted notion of prior transfer pricing guidance by the OECD) according to their “economic substance” in the latest restatement of the OECD Transfer Pricing Guidelines based on conclusions reached and expressed in, and in relation to, Actions 8 – 10 of the OECD’s and G20’s BEPS project, now the focal point of the concerted actions of approximately one hundred and thirty countries included in the OECD’s Inclusive Framework, embracing a variety of initiatives to counter international income “shifting” by multinational enterprises. “Accurate delineation” was embraced as a concept by the CRA at the 2018 Annual Conference of the Canadian Tax Foundation as an expression of the recharacterization notion the statutory tether of which effectively was debated in the Cameco case. The Tax Court’s reasons are undisturbed, even if not in the same terms articulated by the Tax Court, and effectively reinforced by the FCA.
The Crown did not pursue “sham” on appeal. The Tax Court’s decision on this point continues to speak as spoken by the Court. The focus of the appeal to FCA was, as that Court frames the controversy, whether to be within paragraphs 247(2)(b) and (d), the affected transactions have to be those into which the particular taxpayer would not have entered with arm’s length parties or, alternatively, have to be of a sort that arm’s length parties generally – hypothetically – would not have entered. In other words, reflecting how the Court expresses itself in deciding that the answer is the latter and not the former encapsulation, the issue is whether an objective analysis applies – objective to the taxpayer and transactionally objective too – or instead the focus is essentially on personal planning choices made by the taxpayer, including a decision as simple as incorporating a business it could have undertaken directly, with the effect that its income is now the income of another cognizable persons, a subsidiary under the Act.
In keeping with this blog’s attitude about commenting about the merits and arguments of “live” cases – until it is determined that this case will not be appealed further, it is and remains a “live” case – little more will be said except to note the importance of the decision for the transfer pricing world, particularly in how it seems to limit the freedom with which taxpayers’ structural organizational and transactional plan, as such, may be recast (recharacterized) relying on paragraphs 247(2)(b) and (d) of the Act. In this connection, the following paragraphs from the FCA’s reasons invite careful consideration, broadly in Canadian tax practice not just in the transfer pricing realm (the emphasis of aspects of the FCA’s reasons is mine):
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[43] However, subparagraph 247(2)(b)(i) of the Act does not refer to whether the particular taxpayer would not have entered into the particular transaction with the non-resident if that taxpayer had been dealing with the non-resident at arm's length or what other options may have been available to that particular taxpayer. Rather, this subparagraph raises the issue of whether the transaction or series of transactions would have been entered into between persons dealing with each other at arm's length (an objective test based on hypothetical persons) — not whether the particular taxpayer would have entered into the transaction or series of transactions in issue with an arm's length party (a subjective test). A test based on what a hypothetical person (or persons) would have done is not foreign to the law as the standard of care in a negligence case is a "hypothetical 'reasonable person' (Queen v. Cognos Inc., [1993] 1 S.C.R. 87, at page 121, 1993 CanLII 146).
[44] Subparagraph 247(2)(b)(i) of the Act applies when no arm's length persons would have entered into the transaction or the series of transactions in question, under any terms and conditions. If persons dealing at arm's length would have entered into the particular transaction or series of transactions in question, but on different terms and conditions, then paragraphs 247(2)(a) and (c) of the Act would be applicable.
[45] If Parliament had intended that subparagraph 247(2)(b)(i) of the Act would apply if the particular taxpayer would not have entered into the particular transaction with any arm's length person, this subparagraph could have provided:
(b) the transaction or series
(i) would not have been entered between the participants if they had been dealing at arm's length
[46] If the Crown's interpretation is correct, then whenever a corporation in Canada wants to carry on business in a foreign country through a foreign subsidiary, the condition in subparagraph 247(2)(b)(i) of the Act would be satisfied. Because the company wants to carry on business in that foreign country either on its own or through its own subsidiary, it would not sell its rights to carry on such business to an arm's length party.
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[55] There are two problems with this proposed alternative arrangement. The first problem is that paragraph 247(2)(d) of the Act does not ask what one of the participants would have done. Rather, it asks what transaction or series of transactions would have been entered into between persons dealing at arm's length and what would have been the terms and conditions of that transaction or series. This is not, as the Crown suggests, simply asking what only one of the two participants would have done. Rather, it requires the Court to substitute for the transaction or series of transactions entered into between the participants, the transaction or series of transactions that would have been entered into between persons dealing at aim's length.
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[57] In my view, the text of this provision does not support the interpretation as proposed by the Crown. Rather, the words should be interpreted as written. The condition in subparagraph 247(2)(b)(i) of the Act is only satisfied if the transaction or series of transactions is one that would not have been entered into by arm's length persons.
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[81] Parliament has chosen to indirectly address the issue of a Canadian taxpayer shifting profits to a non-arm's length person located in another jurisdiction by implementing the transfer pricing rules found in Part XVI.1 of the Act. These rules will adjust prices paid for goods purchased and sold and for services provided in transactions between a taxpayer and a non-resident person with whom that taxpayer is not dealing at arm's length, if such prices differ from the amount that would be paid in an arm's length transaction. By adjusting prices for goods and services, the profit realized by the Canadian taxpayer will be adjusted. However, the rules in paragraph 247(2)(b) and (d) of the Act are not as broad as the Crown suggests. They do not allow the Minister to simply reallocate all of the profit of a foreign subsidiary to its Canadian parent company on the basis that the Canadian corporation would not have entered any transactions with its foreign subsidiary if they had been dealing with each other at arm's length.
[82] Paragraphs 247(2)(b) and (d) of the Act apply only where a taxpayer and non-arm's length non-resident have entered into a transaction or a series of transactions that would not have been entered into between any two (or more) persons dealing at arm's length, under any terms or conditions. In such a situation, the transaction or series of transactions that would have been entered into between arm's length persons is substituted for the transaction or series of transactions in question, with the appropriate terms and conditions. In particular, paragraphs 247(2)(b) and (d) of the Act cannot be used to simply reallocate all of the profits earned by CEL to Cameco, its Canadian parent corporation, in the circumstances of this case. Of course, in another situation where these paragraphs would apply, the substituted transactions may well result in adjustments to the income (and the profit) of a Canadian taxpayer.
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There is little doubt that this decision, extending as it does the decision of the Tax Court, will give rise to much commentary in the tax world. The interest of this post is to describe its essence and to anticipate what may come next, either as an appeal, or even if not, reflection on the significance and role of “tax law” in the larger legal context, something about which Osgoode’s - and indeed the legal community’s - revered leader Peter Hogg and I wrote several years ago – in part with this sort of situation and regulation by extensions of administrative fiat in mind – in the Osgoode Hall Law Journal.