Tax Alert Canada. TCC dismisses appeal on transfer pricing reassessment of 2003 factoring transactions. Facts

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1 2014 Issue No. 1 7 January 2014 Tax Alert Canada TCC dismisses appeal on transfer pricing reassessment of 2003 factoring transactions EY Tax Alerts cover significant tax news, developments and changes in legislation that affect Canadian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. On 28 December 2013, the Tax Court of Canada (Court) released its 13 December judgment in McKesson Canada Corporation v The Queen (2013 TCC 404). The case concerned a factoring financing transaction between McKesson Canada Corporation (MCC) and its Luxembourg parent, McKesson International Holdings III S.a.r.l. (MIH). A related appeal by MCC addressed the Part XIII withholding tax liability assessed on the value of the dividend deemed conferred by MCC during FY2003 on MIH as a result of the transfer pricing adjustment. After consideration of the evidence presented by both parties and the testimony of several expert witnesses, Justice Patrick Boyle agreed with the Canada Revenue Agency s (CRA s) position on the transfer pricing adjustment and the withholding tax assessment and dismissed both of MCC s appeals. Facts MCC is the principal Canadian operating company and the indirect wholly owned subsidiary of McKesson Corporation (McKesson US), the largest United States public health care company. The McKesson corporate group specializes primarily in the wholesale distribution of above-the-counter pharmaceutical and medical products. The group accounted for roughly one-third of the US and Canadian pharmaceutical distribution market shares during McKesson s customers in the United States and Canada include pharmacies, grocery and department store chains, hospitals, as well as health and long-term care institutions. The disputed factoring transaction was originally put in place on 16 December 2002, when MCC sold all of its eligible third-party trade receivables (approximately

2 $460 million) to MIH under a five-year intercompany factoring contractual arrangement consisting of the Receivables Sales Agreement (RSA) and an accompanying Servicing Agreement. Under the RSA, MCC sold eligible trade receivables to MIH daily at a specified discount from the receivables face value. Under the Servicing Agreement, MCC was retained as a service provider to MIH and was responsible for performing day-to-day monitoring, collection and recording activities associated with the factored receivables. The total face value of outstanding factored accounts receivable remained above the minimum initial contractual limit of $460 million during FY2003. The RSA included a provision whereby MIH had the right to return the unpaid bad receivables to MCC at a 25% discount, which would later be adjusted downward to the amount actually collected by MCC. This provision effectively shifted the liquidity risk of non-performing receivables from MIH back to MCC, but did not protect MIH from default risks on non-performing receivables. The RSA also gave MIH early termination rights which it could exercise in specified circumstances, including the actual or anticipated material deterioration in the creditrisk quality of MCC and the factored receivables. MIH borrowed all funds from one of its Irish indirect parent entities to finance its purchases of factored receivables. This loan was fully guaranteed by another Luxembourg indirect parent entity. During FY2003, MCC sold its receivables at the 2.206% contractual discount from the receivables face value, which amounted to an annualized effective rate of roughly 27%, given the receivables average of approximately 30 days outstanding. The discount rate under the RSA was calculated as the sum of three components, a Yield Rate, a Loss Discount and a Discount Spread. The Yield Rate, intended to reflect a baseline riskfree borrowing rate, was set equal to the 30-day CDOR interest rate. The Loss Discount, intended to reflect the risk of non-payment by obligors, was fixed in the RSA at the weighted average rate of 0.23% for FY2003, subject to an annual recalculation, although MIH had the option to request recalculation on a monthly basis. The Discount Spread was fixed in the RSA at % for the five-year duration of the RSA, making it the largest component of the overall discount rate. The Discount Spread was intended to address several risks including: i) that MIH might be required to appoint a new service provider at a higher cost if the Servicing Agreement were terminated; ii) that the value of the receivables sold may be diluted if more customers took advantage of prompt payment discounts; and iii) that customers would unilaterally offset their obligations to MCC with accrued rebates. It also included an interest discount to fully cover MIH s cost of funds on the loan to finance the purchase of the receivables. Under the Servicing Agreement, MIH paid MCC $9,600,000 per year to collect and administer the receivables, regardless of the amount of receivables outstanding. The CRA did not challenge this arrangement. CRA s position on reassessment In its transfer pricing audit of MCC s FY2003 factoring transactions, the CRA challenged that the discount rate on the receivables sold by MCC to MIH was greater than the rate that would be provided to MIH in an arm s-length factoring transaction. The CRA did not challenge the Yield Rate calculation but did challenge the quantum of the other two components of the discount rate formula. The CRA concluded, based on its own quantitative transfer pricing analysis, that the arm s-length discount rate on the receivables sold by MCC would be equal to % during FY2003, which is equivalent to an annualized effective rate of roughly 13%. The CRA reassessed MCC for the difference between the original discount rate and the CRA s computed discount rate, resulting in a transfer pricing TCC dismisses appeal on transfer pricing reassessment of 2003 factoring transactions 2

3 adjustment of $26,610,000. A transfer pricing penalty was not assessed. The CRA also assessed MCC for Part XIII withholding tax of 5% of the transfer pricing adjustment for failing to withhold tax on the excess amounts paid to MIH as determined by the transfer pricing adjustment. Positions of the parties MCC argued that the terms and conditions of the covered intercompany factoring transaction and the quantum of the discount were equivalent to what would be applied by arm s-length parties in similar factoring market transactions. MCC s position relied heavily on an analysis prepared by Toronto Dominion Securities Inc. (TDSI) at or around the time the RSA was put in place in December TDSI s primary experience was in the securitization of receivables, which was not directly parallel to the transaction under the RSA. The TDSI approach involved identifying the distinct elements of risk accruing to MIH under the RSA and, based on its experience, pricing these separate elements. The discount rates determined for each of these elements was then aggregated to determine an overall discount rate. The CRA s argument focused on the selection of an appropriate transfer pricing approach and the related calculation of an arm s-length discount rate for the factoring transaction. In his decision, Justice Boyle commented (at para. 167) that the Crown s argument wisely stuck to the relevant statutory provisions and the evidence and did not indirectly raise any fair share or fiscal morality arguments, which Justice Boyle indicated were surely the realm of Parliament. Both parties called expert witnesses on matters relating to the arm s-length nature of the factoring transaction s terms and conditions, MCC s transfer pricing approach, the choice of the most appropriate transfer pricing approach and the quantum of the calculated factoring discount rate. Tax Court of Canada decision The Court reviewed MCC s technical approach to calculating the factoring discount rate and compared it to the pricing approach and the quantum used by the CRA in making its reassessment. Justice Boyle reviewed the transaction from a high-level perspective, providing several comments on the relevant risk implications for the parties, contractual substance and related financing transactions. He made extensive comments on the experts reports and testimony. Although he did not accept the conclusions of any of the experts or their reports in their entirety, he acknowledged that his analysis was informed by the testimony and information provided by the expert witnesses. Justice Boyle accepted that MCC s transfer pricing approach for calculating the factoring discount rate was appropriate in this case, and reviewed each of the three core components of the calculated discount rate in detail to consider whether the terms and conditions which affected the discount rate differed from those that would be expected between arm s-length persons. In doing so he was pointedly critical of a number of assumptions and calculations made by TDSI in its analysis (and made by others in support of that analysis). For the Yield Rate, Justice Boyle accepted that the annual CDOR rate, adjusted to reflect the much shorter period over which receivables would be collected (referred to as Days Sales Outstanding, or DSO), was appropriate. However, he concluded that DSO should be floating, recomputed every three or four months, rather than fixed at days for the entirety of the RSA. Most important, Justice Boyle concluded that DSO for the original $460 million of receivables purchased on 16 December 2002 should not have been averaged over the entire five-year term of the RSA. Justice Boyle concluded that the appropriate DSO was 30 days throughout FY2003 (based on a four-month rolling average). Applying the annual CDOR rate of 2.79%, adjusted to 30 days for two of the three settlement dates in FY2003 and one-half of this amount for the first settlement date (to account TCC dismisses appeal on transfer pricing reassessment of 2003 factoring transactions 3

4 for the initial purchase of receivables on 16 December), Justice Boyle concluded that Yield Rate component for FY2003 should be %. The Court did not accept MCC s approach or rationale in calculating the Loss Discount the second component of the discount rate. The Court concluded that the historic loss performance was 0.04% and, allowing for a 50% to 100% increase (as an extremely generous interpretation of a material change in the credit loss risk), would set the Loss Discount at 0.06% to 0.08% for FY2003, well below the 0.23% rate applied by MCC. The Court also disagreed with MCC on certain aspects of the pricing approach and structure of the Discount Spread the third component of the discount rate. Looking at each of the four elements that made up this component servicing, prompt payment dilutions, accrued rebate dilutions and interest discounts Justice Boyle determined that an arm s-length Discount Spread was within a range of 0.67% to 0.86%, as opposed to the % rate applied by MCC. He was particularly critical of the accrued rebate dilution discount, considering it unsupported and not warranting any material discount, and of the interest discount, finding as a general rule, the value of an asset sold is not generally affected by a particular purchaser s cost of funds. The total factoring discount rate estimate determined by the Court was calculated at 0.959% 1.17% or lower, depending on the choice of the Yield Rate estimate in the discount rate formula. MCC s overall discount rate of 2.206% was materially above the discount rate range computed by the Court, while the rate of % the CRA used was within the range computed by the Court. Consequently, the Court dismissed MCC s appeal, also noting that a reassessment to the higher 1.17% rate in the Court s determined range was not appropriate. According to the Court, that would reward overreaching taxpayers who would then count on the court process to ensure they enjoyed the highest permissible transfer price. The Court also dismissed the appeal on the Part XIII withholding tax assessment. MCC had argued that the Part XIII assessment was statutebarred under the Canada-Luxembourg Treaty. Justice Boyle concluded that the five-year limitation contained in Article 9 of the Treaty did not apply to a Part XIII assessment of a taxpayer for failing to withhold on an amount subject to Part XIII tax. Rather, the treaty limitation applied only to primary transfer pricing adjustments (and not the withholding tax assessable on secondary adjustments). Transfer pricing implications The McKesson Canada case has several important implications for transfer pricing in Canada and abroad: 1. In interpreting Section 247 of the Act, the Court reiterated the importance of performing adjustments to account for material differences between intercompany contractual terms and conditions and the terms and conditions that arm s-length parties would normally agree to. Under paragraphs 247(2)(a) and (c), the Court is not limited to adjusting amounts, but can revise the terms and conditions to conform to what arm slength parties would have agreed to. 2. Justice Boyle specifically commented that he saw no compelling reason to depart from the Supreme Court of Canada s approach and comments in GlaxoSmithKline even though that case concerned former subsection 69(2) and that section 247 does not use the phrase reasonable in the circumstances. According to Justice Boyle (at para. 121), arm s-length persons should generally be assumed for purposes of section 247 to act neither irrationally nor unreasonably and should be expected to transact for products and services at amounts within the range of their fair market value having regards to all relevant circumstances. 3. Copthorne Holdings Ltd. v The Queen and Alberta Printed Circuits v The Queen were referenced to confirm that all relevant transactions, agreements and control rights should be considered by the Court if they TCC dismisses appeal on transfer pricing reassessment of 2003 factoring transactions 4

5 effectively constitute a series of related transactions and if such considerations can have a material impact on transfer pricing in the transaction in issue. 4. An other method is acceptable as a valid analytical transfer pricing analysis methodology when the four core OECD transfer pricing methods cannot be reliably applied to an intercompany transaction. 5. Both a comparable transaction (top-to-bottom) approach and a build-up (bottom-up) approach may be appropriate to determine an arm slength transfer price. The comparable transaction approach starts with a comparable market price applicable in a similar arm slength transaction and then makes a series of adjustments to account for material differences between the comparables and the covered intercompany transaction. The buildup approach effectively constructs an arm slength transfer price by combining one or several core price inputs and then performing a series of material quantitative adjustments to arrive at the final price matching all material terms and conditions of the covered intercompany transaction. 6. Risk transfer arguments and market pricing evidence on relevant risk transfer instruments can be fully taken into account by the Court when analyzing a transfer price. Therefore it is in the best interests of taxpayers to document such analyses. 7. In appropriate circumstances, where it is possible to do so, prices for distinguishable and identifiable components of a transaction should be separately determined and then aggregated. Conclusion The McKesson decision is a significant addition to the growing body of Canadian transfer pricing jurisprudence. Given that the CRA has likely reassessed MCC for additional years under the RSA, it will be interesting to see whether MCC appeals the decision to the Federal Court of Appeal and, if so, how the FCA will dispose of the appeal. Learn more For more information, contact your EY or Couzin Taylor advisor or one of the following professionals: John Oatway, Leader, Transfer Pricing Services john.oatway@ca.ey.com Toronto Andrew Clarkson andrew.clarkson@ca.ey.com Sean Kruger sean.kruger@ca.ey.com Ken Kyriacou ken.kyriacou@ca.ey.com Lori Whitfield lori.whitfield@ca.ey.com Quebec and Atlantic Canada Rachel Spencer rachel.spencer@ca.ey.com Alfred Zorzi alfred.zorzi@ca.ey.com Ottawa Rene Fleming rene.fleming@ca.ey.com Phil Fortier phil.fortier@ca.ey.com Sandy Goldberg sandy.goldberg@ca.ey.com Paul Mulvihill paul.f.mulvihill@ca.ey.com Fred O Riordan fred.r.oriordan@ca.ey.com Tony Wark tony.wark@ca.ey.com Gary Zed gary.zed@ca.ey.com TCC dismisses appeal on transfer pricing reassessment of 2003 factoring transactions 5

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