On Wednesday, February 3, 2021, the Canadian Tax Foundation hosted its Day 1 Program of the Transfer Pricing Conference virtually. Dialogues between the tax authorities and the private practice sector went back and forth on four panels. The highlight of the discussions was the recharacterization rules in paragraphs 247(2)(b) and (d) of the ITA.
Canada is arguably a legal substance jurisdiction. Taxpayer’s legal relationships must be respected absent a finding of sham or a specific provision of the Act to the contrary (Shell Canada Ltd v Canada, [1999] 3 SCR 622). The recharacterization rules under paragraphs 247(2)(b) and (d) constitute such “a specific provision of the Act to the contrary”. Sham is a high bar to cross and the recharacterization rules will only apply when certain conditions are met.
The CRA cancelled the IC87-2R International Transfer Pricing as of December 30, 2019 and it no longer took the position that recharacterization was the last resort. With this change of position, the CRA’s Transfer Pricing Review Committee is seeing an increased number of recharacterization cases (23 for 04/2017 - 03/2018, 25 for 04/2018 - 03/2019, 37 for 04/2019 - 03/2020, and 58 for 04/2020 - 01/2021). When being asked about the risk of double taxation, the CRA seemed to take the position that it would not consider such risk in applying the recharacterization rules; the risk should be the taxpayer’s concern when they entered into the transactions in issue.
The discussions on the recharacterization rules became more specific in Panel 4 Selected Topics in Transfer Pricing. The first selected topic was an example on delineation in OECD/G20 BEPS Actions 8-10. When being asked whether this OECD example will also fall under the recharacterization rules, the CRA took the position that it would apply paragraphs 247(2)(b) and (d) in a way that is close to the OECD’s Guidelines, even if the latter are not law per se in Canada. When being asked whether the CRA is lowering the bar for applying recharacterization rules by turning to the OECD delineation rule, the CRA seemed to refer to the OECD delineation as a back-door recharacterization.
Similar discussions occurred regarding the example in the Notice to Tax Professionals (July 2019). The Notice concerned a specific type of loan arrangement involving hybrid entities. The CRA took the position that arm’s length parties will not have entered into such a loan arrangement and paragraph 247(2)(b) will apply. The panelist from the private practice sector pointed out that the loan arrangement had “legal substance” since actual money went in there. The discussion further led to the question on the boundaries between the legal substance analysis, OECD delineation rule, and the recharacterization rules in paragraphs 247(2)(b) and (d).
The discussions went on and the panelists cannot agree on whether the taxpayer’s loan arrangement should be respected. However, the panelist from the CRA did point out that the Crown is seeking leave for Canada v Cameco Corporation (2020 FCA 112), an important decision on recharacterization rules. Moreover, a new revised circular on transfer pricing will be released by the CRA. Hopefully we will then be provided with some clarifications on the recharacterization rules.