Tax Court of Canada releases decision in Marzen Aluminum transfer pricing case

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1 20 June 2014 Global Tax Alert News from Transfer Pricing EY Americas Tax Center The EY Americas Tax Center brings together the experience and perspectives of over 10,000 tax professionals across the region to help clients address administrative, legislative and regulatory opportunities and challenges in the 33 countries that comprise the Americas region of the global EY organization. Copy into your web browser: Services/Tax/Americas-Tax- Center---borderless-clientservice Tax Court of Canada releases decision in Marzen Aluminum transfer pricing case Executive summary On 10 June 2014, the Tax Court of Canada released its judgment in Marzen Artistic Aluminum Ltd. v The Queen (2014 TCC 194). These appeals of the taxpayer s 2000 and 2001 taxation years arise out of a transfer pricing adjustment made by the Canada Revenue Agency (CRA) in respect of fees paid by Marzen to Starline International Inc. (SII), a Barbados-based corporation wholly owned by the taxpayer. Marzen had deducted $4,168,551 in 2000 and $7,837,082 in 2001 in respect of fees paid to SII for services. The CRA reassessed to disallow $2,110,502 of the SII fees in 2000, and $5,025,190 in 2001, effectively not allowing a deduction of any amount for services performed by SII. After consideration of the evidence presented by both parties and the testimony of several witnesses, Justice Sheridan of the Tax Court of Canada held that, for the purpose of s. 247 of the Income Tax Act (the Act), an arm s-length s party would have paid only US$32,500 in each of the years under appeal for the services provided by SII. With respect to the transfer pricing penalty assessed, Justice Sheridan found that the information and documentation the taxpayer furnished to the CRA was not sufficient to preclude application of the penalty assessed by the Minister for the taxpayer s 2000 and 2001 taxation years. Detailed discussion Facts In the relevant years, the taxpayer was a designer, manufacturer and seller of aluminium and vinyl window products in British Columbia. The taxpayer s sole director was Mr. Ron Martini. Starline Windows Inc. (SWI) was located in Washington State. SWI was a tax resident of the United States, where it filed tax returns for the taxation years 1998 to In April 1998, Mr. Rick Stark became the general manager of SWI.

2 Like the taxpayer in Canada, SWI s initial focus in Washington State was the residential window market. SWI purchased window products from the taxpayer at a price that would provide a margin of 15%-18%. SWI personnel solicited orders for window products from US customers. In 1998, SWI had sustained significant losses of US$487,000 from its activities in the US. Mr. Martini and his right hand man Mr. Fabian met with counsel for the taxpayer to discuss the utilization of SWI s losses. They were referred by counsel to Mr. David Csumrik, a resident of Barbados, as a marketing person who could help them. Mr. Csumrik quickly concluded that the taxpayer was focussed on the wrong market in the US. He advised Mr. Martini and Mr. Fabian to shift the taxpayer s efforts from Washington State s residential market to the highrise market in southern California, with a view to targeting Western Canadian developers building in the area. However, contrary to certain written representations made by the taxpayer during the audit, at trial Mr. Csumrik admitted that he himself had no contacts with such developers. SII was incorporated in Barbados in 1998 by Mr. Csumrik, the principal of Longview Associates Limited (Longview), shortly after he initially met Mr. Martini and Mr. Fabian. Longview provided corporate services to companies registered in Barbados, such as maintaining books of account, preparation of financial statements, keeping business registrations current with the Barbados authorities and preparation of Barbados tax returns. The usual fee for such services was US$30,000 annually. Initially, Mr. Csumrik acted as SII s sole director. On 11 February 1999 the taxpayer became the sole shareholder of SII, and Mr. Csumrik became SII s managing director, with two other directors also being appointed at that time, Mr. Stark and Mr. Terry Vipond, the son-in-law of Mr. Martini. Thereafter, Mr. Martini and his family directly or indirectly controlled the taxpayer, SII and SWI. Thus, the taxpayer, SII and SWI were deemed under the Act not to deal at arm s length. In early spring 1999, Mr. Martini and Mr. Csumrik reached a handshake agreement regarding Mr. Csumrik s compensation. Under this agreement, if Mr. Csumrik s advice proved successful, Mr. Csumrik, in his personal capacity, would be remunerated by Mr. Martini and/ or the taxpayer in some fashion at an undetermined time in the future. At the time of the trial, no compensation had been provided to Mr. Csumrik under this arrangement. Legal arrangements On 1 July 1999, four agreements were executed to put in place a new structure for marketing the taxpayer s window products in the US. The most relevant agreement was the Marketing and Sales Services Agreement (MSSA), which addressed the transaction under appeal. Under the MSSA, SII was described as being in the business of marketing products such as the taxpayer s window products. The taxpayer also agreed under the MSSA to pay SII a monthly fee equal to the greater of US$100,000 or 25% of gross sales initiated by SII. Mr. Martini gave the following explanation of how the 25% formula was determined: The cost of sales in Canada for Marzen was 14 percent, 14 to 15 percent. Our cost here in Canada. So we are selling in a market where everybody knows we don t have to go and look for new customers, repeated customer. I felt that if we go in the new country and if I have to market to people that don t know us, 25 percent was reasonable. Although the 25% marketing fee was greater than SWI s costs under the pre-july 1999 regime, Mr. Martini believed the taxpayer could still make a profit because of the increased volume of sales. He said he did not use any comparable businesses in determining the fee formula because he could not identify any, and admitted he had not sought professional assistance to advise him to that end, nor had he reduced to writing the basis for his decision. SII and SWI also entered into a Personnel Secondment Agreement (the PSA), under which SWI agreed to provide the services of personnel on an exclusive basis to be retained and engaged by SII in the marketing of the taxpayer s products in the US and elsewhere. SII would pay SWI a monthly fee to cover SWI s aggregate costs of the employment of the personnel plus a service fee of 10%. No explanation was given as to how the 10% markup on costs was determined, except that SWI should derive some profit from its services. 2 Global Tax Alert Transfer pricing

3 An Administrative and Support Services Agreement (ASSA) between SII and SWI was also put in place in which SWI agreed to provide certain secretarial and other administrative support services to SII. SII agreed to pay SWI monthly fees, as amended from time to time. Under a Delivery/Depot/Repair & Maintenance Services Agreement between the taxpayer and SWI, SWI agreed to provide certain services in relation to the delivery, depot, repair and maintenance of window products as well as certain bill collection and enforcement duties. The effect of this agreement was that the taxpayer covered all of SWI s costs related to these services. In 2000, an amendment was made to the MSSA at Mr. Csumrik s suggestion to provide that the taxpayer would pay SII a one-time bonus of 10% on all confirmed contracts in the California market on condition that SII achieve at least US$10 million in net sales between 1 August 2000 and 31 December At trial, Mr. Martini testified that he did not know how Mr. Csumrik had arrived at the 10% formula, but he had no reason to think the 10% amount was unreasonable. As it turned out, the total sales greatly exceeded the required minimum and the bonus payment was of US$2,090,422. None of that amount went to benefit Mr. Csumrik nor reflected expenses that SII incurred to pay SWI for extra workers or extra marketing efforts in California. Under a separate arrangement, Longview provided SII with Mr. Csumrik s personal services as managing director of SII for US$2,500 annually, and local management and administrative services for US$30,000 annually. These amounts were in accordance with Longview s usual rates for such services. As a result of all these agreements, in computing its income for the 2000 and 2001 taxation years, the taxpayer deducted the fees paid to SII of CAD$4,168,551 and CAD$7,837,082, respectively. In 2000 and 2001, SII paid SWI a total of US$1,383,723 and US$1,811,992, respectively, for the services provided under the PSA and ASSA. In the same years, SII declared dividends to the taxpayer of CAD$2,011,500 and CAD$5,299,620, respectively. The taxpayer included these amounts in its income for Canadian tax purposes in the 2000, 2001 and 2002 taxation years, but the dividends were then deducted from the taxpayer s taxable income pursuant to section 113 of the Act on the basis that they had been paid out of SII s exempt surplus. Issues At issue was whether, based on the transfer pricing rules under s. 247 of the Act, the Minister was correct in disallowing the deductions claimed by Marzen in the amounts of $2,110,502 and $5,025,190 for the 2000 and 2001 taxation years, respectively, which were in excess of the amounts SII paid to SWI, and in assessing a penalty in the amount of $502,519 for the 2001 taxation year. Specifically at issue were the following: Whether the terms and conditions imposed under the MSSA differed from what would have been agreed to by persons dealing at arm s length. If yes, what adjustments should be made to the quantum of the fees that the taxpayer paid SII under the MSSA to make it equivalent to the price that would have been paid had the taxpayer and SII been dealing at arm s length. Whether the taxpayer was liable to a penalty under s. 247(3) in respect of the transfer pricing adjustment made for its 2001 taxation year. The reassessment In reassessing the taxpayer s 2000 and 2001 taxation years, the Minister disallowed Marzen the deduction of any amounts paid to SII under the MSSA in excess of the fees SII paid to SWI under the PSA and ASSA, and assessed a penalty in the amount of $502,519 for the 2001 taxation year (the penalty threshold was not reached in the 2000 taxation year). The parties positions Taxpayer The taxpayer s position was that having regard to the agreements put in place by the taxpayer and SII, the terms and conditions adopted by the parties regarding the services provided directly and indirectly by SII did not differ from those that would have been agreed upon between arm s-length parties. The taxpayer contended that the Court must take into account both Global Tax Alert Transfer pricing 3

4 the direct services that SII provided and also the indirect services that SWI employees rendered under the PSA. The taxpayer s positions also rested on the argument that SWI and SII must be treated as one entity, referred to as an amalgam, whose functions included Mr. Csumrik s involvement. This factual assumption formed the basis of the taxpayer s expert report and informed its approach to the transfer pricing analysis. The taxpayer relied heavily on its position that Mr. Csumrik, on behalf of SII, collaborated with SWI to undertake the marketing of the taxpayer s window products in the US, developed the marketing strategy used under the agreements and provided ongoing supervision and advice to SWI in furtherance thereof. The taxpayer also contended that the proof is in the pudding, since after the agreements were put in place, the taxpayer achieved an impressive increase in US sales, which it contended was proof in itself that the payment of the fees under the MSSA was justified. The Crown The Crown s position was largely based on the fact that there was no evidence to show that SII provided any meaningful services, or that such services would have justified, to an arm s-length person, the payment of the majority of the fees paid under the MSSA. In making an adjustment to the price under the MSSA, the Minister concluded that only the amount SII paid to SWI under the PSA and the ASSA was an arm s-length amount. Nevertheless, in response to the taxpayer s argument at trial regarding the effect of one of the auditor s admissions on discovery, the Crown acknowledged that it was Mr. Csumrik who came up with the game-changing idea and that he provided some useful suggestions and strategic advice and reconciled sales reports on a weekly basis. Notwithstanding these small concessions, the Crown submitted that the evidence did not support the conclusion that Mr. Csumrik provided much, if anything, by way of meaningful value-added services to marketing window products or generating US sales. According to the Crown s analysis, the emphasis the taxpayer placed on the assertion that Mr. Csumrik was to be compensated for his efforts under a separate arrangement between Mr. Csumrik and the taxpayer and/or Mr. Martini resulted in a double paradox: the more the taxpayer emphasizes the unique value of Mr. Csumrik s contribution to SII s performance of its marketing obligations in justification of the fees paid to SII, the more unreasonable it seems that Mr. Csumrik would have provided such services for only minimal compensation. If, as the taxpayer alleges, Mr. Csumrik s real incentive for creating such value for SII was a separate compensation agreement with the taxpayer and/ or Mr. Martini, that only begs the question of what the taxpayer paid SII the fees for. The Crown also rejected the taxpayer s treatment of SII and SWI as a single entity for its transfer pricing analysis, arguing that the arm s-length principle requires an entity-by-entity approach. Tax Court of Canada decision Justice Sheridan agreed with the Crown s argument that SII was an empty shell with no personnel, no assets and no intangibles or intellectual property. After highlighting the fact that SWI provided sales and marketing staff to SII at an arm s-length price under the PSA and ASSA was not in issue, she concluded that the key to determining the services provided by SII was identifying the role played by Mr. Csumrik. She determined that Mr. Csumrik provided his only substantial advice as to the importance for SWI to change its market focus in his personal capacity directly to Mr. Martini and the taxpayer before the implementation of the agreements. This was fatal to the taxpayer s argument. Justice Sheridan s finding that no part of the MSSA fees was intended to compensate for Mr. Csumrik s advice was also material: If Mr. Csumrik, on behalf of SII, was really performing the crucial marketing services attributed to him under the taxpayer s argument, why would he have done so for nothing more than a managing director s annual stipend? Common sense dictates that he would not have. She also pointed out that the taxpayer s amalgam argument rested largely on the overstated role Mr. Csumrik actually played. With regard to his role, she only considered the above-noted concessions made by the Crown. 4 Global Tax Alert Transfer pricing

5 With regard to the taxpayer s expert report, Justice Sheridan found that many of the factual assumptions in the report regarding the nature of Mr. Csumrik s involvement in SII s and SWI s activities were unfounded, and the assumption that SWI and SII operated as an amalgam under Mr. Csumrik s direction made it fundamentally flawed in that it wrongly identified the transaction under review as being between the taxpayer and the SWI/SII amalgam, and that such treatment of SWI and SII as one entity was contrary to the OECD Guidelines. For these reasons, she chose not to rely on the taxpayer s expert report. As to the taxpayer s proof is in the pudding argument, Justice Sheridan came to the conclusion that it was clear from the taxpayer s own evidence that the increase in sales might have just been related to good timing. She also highlighted that the important financial results were mainly achieved by SWI, and that the fees paid to SII accounted for the taxpayer s largest expense. At the same time that the taxpayer was reporting losses from its operations, SII s profits were generating healthy dividends for the taxpayer. The fact that the dividends were used to expand the taxpayer s Canadian business operations also did little to advance the taxpayer s case. Justice Sheridan concluded that: the taxpayer put the dividends to good use hardly justifies its payment of fees to SII under the MSSA. As for the taxpayer s obligation to provide funding under Clause 3.2 on demand and in excess of the fees already imposed under the MSSA the taxpayer s argument does not address how that would be palatable to an arm s-length party who lacked the taxpayer s capacity to recoup such funds through dividend payments. No serious negotiations were found to have taken place to support the rationale behind the fees paid by Marzen to SII under the MSSA. Justice Sheridan agreed with the Crown s argument that the only inference to be drawn is that the taxpayer paid the fees to SII to secure a tax benefit. The only reasonable explanation for the taxpayer to have agreed to pay SII under the MSSA was so the fees could be reported as profits and then returned to the taxpayer as exempt surplus dividends. Meanwhile, the marketing fees could be deducted from income for Canadian tax purposes. None of these attractive advantages would have been available to an arm s-length party. Based on all these findings, Justice Sheridan concluded that the terms and conditions of the MSSA differed from what would have been agreed upon had the taxpayer and SII been dealing at arm s length, and that an arm s-length party would not have paid the marketing fees that the taxpayer did in the 2000 and the 2001 taxation years for the services that SII provided. She then considered the second issue of determining what adjustments should be made to the quantum of the fees that the taxpayer paid to SII under the MSSA. In doing so, she referred to both parties reliance on the principles established in Canada v GlaxoSmithKline (2012 SCC 52), The Queen v General Electric Capital of Canada (2010 FCA 344) and Alberta Printed Circuits Ltd. v The Queen, 2011 TCC 232, and on the 1995 OECD Guidelines and the CRA s IC 87-2R. She approved of the reliance by the Canadian courts on the OECD Guidelines as a tool to assist in determining what a reasonable business person would have paid if the parties to a transaction had been dealing with each other at arm s length. The decision in particular highlighted the Supreme Court of Canada s statements in GlaxoSmithKline that transfer pricing analysis is strongly fact driven and that when assessing the evidence, the trial judge must keep in mind the respective roles and functions [of the parties to the transfer pricing transaction]. Justice Sheridan maintained that the critical first step in a transfer pricing analysis is to identify the transaction under review, which in this case was the services provided under the MSSA. It was then necessary to make an entity-by-entity assessment of roles and functions. Under this analysis, the taxpayer did not persuade Justice Sheridan that Mr. Csumrik s conceptualization and development of the marketing strategy could have been attributed to SII. Nevertheless, she found that Mr. Csumrik provided ongoing direction to the SWI sales team by way of reviewing sales reports and providing some strategic advice and suggestions to SWI on behalf of SII. This conclusion permitted her to Global Tax Alert Transfer pricing 5

6 take into account some value added by the services of SII to support the taxpayer or SWI. In so doing, she then accepted the Crown s submission that the CUP method could be applied to determine the value of the services as US$32,500 in each of the 2000 and 2001 taxation years the same amount as the fees paid by SII for the services of Longview and Mr. Csumrik. Penalty Reassessments of the taxpayer s 2000 and 2001 taxation years that should follow from Justice Sheridan s conclusion on deductibility (to allow $32,500 of fees) should render the application of subsection 247(3) moot, as the $5,000,000 threshold for its application would then not be reached in either year. Nevertheless, Justice Sheridan went on to consider whether the taxpayer made reasonable efforts to determine and use arm s-length transfer prices for the purposes of the Act. She found as a factual matter that the letter the taxpayer sent with information intended to fulfil the requirement was not sufficient to satisfy the reasonable efforts standard. Transfer pricing implications The Marzen case has several important implications for transfer pricing in Canada: Contractual arrangements in themselves are insufficient to support transfer pricing. The Court seemingly accepted that the arrangements among Marzen, SII and SWI were legally effective, but the arrangements in themselves did not justify the amounts paid to SII without SII having functional substance performing some function of value to justify the payments made to it. The OECD Transfer Pricing Guidelines are of significant interpretive value. Justice Sheridan referred to the Guidelines generally and on specific points of contention to support her findings, and noted their acceptance by Canadian courts as an interpretive tool. The legal form of transactions must be respected. The taxpayer put forth that SII and SWI should be treated as an amalgam, or single entity, to determine the reasonableness of the overall arrangement, and its expert report was prepared on this basis. Justice Sheridan rejected this approach, as it did not properly identify the transaction and was at odds with the arm s-length principle as contemplated by the OECD Guidelines. Analysis and documentation of transfer prices is critical. At several junctures, the taxpayer merely ballparked or guessed at what it considered to be reasonable arrangements without seeking empirical corroboration or professional analysis. The provision of services should be well documented. The taxpayer was unable to demonstrate that services were provided by SII in any substantive way. The CRA contended that there was no evidence provided of services taking place, and Justice Sheridan agreed. Although not discussed in the decision, it would also be expected that the services provide a demonstrable benefit to the Canadian taxpayer. The CUP method can be applied to services. Justice Sheridan accepted (and the CRA supported) that the services provided by Longview to SII served as a valid CUP for the services SII provided to Marzen in providing administrative services and ongoing direction of SWI s activities. The onus is on the taxpayer to support that reasonable efforts have been made to document and use arm s-length transfer prices in order to avoid penalties. Justice Sheridan found that in the absence of the taxpayer providing adequate documentation, the taxpayer could not shift the burden of compliance to the CRA by suggesting a responsibility on the Agency s part to identify inadequacies to the taxpayer for rectification. Implications The Marzen decision adds to the growing body of Canadian transfer pricing jurisprudence. Given the lack of evidence the taxpayer was able to present, its impact, however, is seemingly limited, at least in terms of providing guidance on the pricing of transactions. It does, however, provide a cautionary tale to taxpayers about tax structuring into arrangements that do not substantively provide additional value to existing transactions, and where the functions performed are not perceptibly different from the previous structure. 6 Global Tax Alert Transfer pricing

7 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP (Canada), Toronto John Oatway, Leader, TP Services Andrew Clarkson Sean Kruger Ken Kyriacou Lori Whitfield Ernst & Young LLP (Canada), Quebec and Atlantic Canada Rachel Spencer Alfred Zorzi Ernst & Young LLP (Canada), Ottawa Rene Fleming Phil Fortier Sandy Goldberg Paul Mulvihill Fred O Riordan fred.r.oriordan@ca.ey.com Tony Wark tony.wark@ca.ey.com Gary Zed gary.zed@ca.ey.com Ernst & Young LLP (Canada), Prairies Lawrence Greer lawrence.a.greer@ca.ey.com Ernst & Young LLP (Canada), Vancouver Greg Noble greg.noble@ca.ey.com Matthew Sambrook matthew.sambrook@ca.ey.com Couzin Taylor LLP, Canada David Robertson david.d.robertson@ca.ey.com Daniel Sandler daniel.sandler@ca.ey.com Louis Tassé louis.tasse@ca.ey.com Roger Taylor roger.taylor@ca.ey.com Global Tax Alert Transfer pricing 7

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