Selected Canadian litigation aspects of international pricing disputes: effect of proposed changes.

• Author: Borraccia, Salvador M.

Since the Tax Reform Act of 1986 in the United States introduced the so-called super-royalty provision, transfer pricing has received an increasing amount of attention both from government and business. The United States is Canada's largest trading partner and the effect of U.S. developments on Canadian corporations dealing with related U.S. corporations will be significant.

Canadians have been largely successful in resolving transfer-pricing disputes prior to litigation, especially those with U.S. corporations. Competent authority has been one of the major reasons. Will this continue? This article explores the Canadian administrative and judicial attitude to the resolution of such disputes and attempts to assess the future effect of recent Canadian and U.S. developments.

1. The Statutory Framework for the Assessment

   The basic Canadian charging provisions are subsections 69(2) and (3) of the Income Tax Act.(1) The former governs payments to a non-resident person with whom a Canadian taxpayer was not dealing at arm's length;(2) the latter, inadequate consideration paid to a Canadian taxpayer in the same circumstances. The common benchmark is the amount that would have been reasonable in the circumstances had they been dealing at arm's length.(3) The provisions are extremely broad and catch virtually all intercompany property or service transactions.

   Revenue Canada has essentially adopted the OECD approach to intercompany pricing and has stated that the comparable uncontrolled price method is to be favored if obvious comparables are available.(4) Revenue Canada recognizes that the application of this method tends to be restricted by the difficulty in establishing that the product involved, market, credit terms, reliability of supply, and other pertinent circumstances may not be comparable. It further believes that variations in the respective circumstances should be minor or capable of quantification on some reasonable basis. In the event that a comparable uncontrolled price cannot be determined, it accepts other methods. The other three methods are cost-plus, resale price and the so-called fourth method -- really any other method that may be used in the circumstances. Revenue Canada, however, takes the transactional approach to intercompany pricing and believes that each transaction must stand on its own merits. It recognizes the role of functional analysis in establishing prices resulting in a quantum of income being taxed in Canada consistent with the real profit contribution of the Canadian taxpayers involved. In fact, Revenue Canada's audit guidelines suggest that formula methods such as group profit allocation (eg., based on percentage of Canadian to worldwide sales or costs) may be suitable in some circumstances but usually only as a last resort.(5)

   Revenue Canada has not published any formulae, benchmarks, or safe havens upon which taxpayers may rely. This may be owing to the difficulties in addressing many divergent situations. Unfortunately, this produces a great deal of uncertainty for taxpayers who must struggle with little official guidance.

2. Pricing Disputes in the Canadian Courts

   Although few pricing cases have made their way through the Canadian tax courts, some principles have evolved that provide insight into the course the Canadian courts may follow in the future.

   1. Onus of Proof

      In his reply to the taxpayer's notice of appeal, the Minister of National Revenue pleads the facts or assumptions of fact upon which his assessment is based and states the reason for the assessment. The Minister's facts are assumed to be correct and the onus is on the taxpayer to demolish the exact assumptions made by the Minister at the time of the assessment.(6) The taxpayer can show that the Minister's facts are incorrect or incomplete and that his own evidence is to be preferred. He can also show that the Minister's position is not correct in law. Inasmuch as a pricing case is normally factual, the taxpayer's evidence typically shows that the disputed amount would have been reasonable in the circumstances had the parties been dealing at arm's length. A statement by the Minister that the amount was not reasonable is a conclusion based upon the facts assumed by the Minister. The reasonableness of the amount is for the court to determine.

      If the taxpayer's evidence is sufficient to rebut the Minister's facts, the onus will shift to the Minister to adduce further evidence in support of the assessment. Most often, the Minister attempts this through cross-examination of the taxpayer's witnesses and introduction of his own evidence (e.g., testimony by the tax auditor or expert witnesses).

      A significant advantage accrues to the taxpayer -- the knowledge of his company and the industry in which it operates. The taxpayer, if properly guided, is often in the better position to develop comparables, especially from outside Canada, and other evidence necessary to prove his case and appreciate the reason for variances.

      If the Minister arbitrarily determines the relevant amount, his assessment can be upset with the minimal of evidence. For example, in Central Canada Forest Products Limited v. M.N.R.,(7) the taxpayer was a shell Canadian corporation that was used as a convenient legal entity to obtain pulpwood rights from the province of Ontario. It then transferred the equity in them to its American parent company at its cost. The Minister felt that the appellant had achieved a bargain in acquiring the rights from Ontario based upon comparisons to allegedly similar contracts entered into by other companies. The comparables were to unnamed companies, but the evidence showed that the timber limits used for the comparisons were a great distance away from those relevant to the appeal.

      The Tax Appeal Board noted that the Minister had not given any expert evidence concerning value, thereby leaving the Board to deal with the matter on the basis of unsatisfactory and flimsy evidence. An important fact was taken to be that the timber rights had been obtained by the appellant as a result of a public sale that had called for sealed tenders in which the appellant's was the highest. The Minister failed to adduce any evidence to establish the similarity of the comparables used by him and, therefore, the evidence adduced by the appellant was sufficient to discharge the onus on it. Although the case is not important for its facts or...