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Transfer Pricing: Ruling Highlights Importance of Arm’s Length Standard and ‘Reasonable Efforts’

03/02/2016


In a 3-0 ruling made public on February 2, 2016, Canada’s Federal Court of Appeal (“FCA”) rejected Marzen Artistic Aluminum Ltd.’s (“Marzen”) appeal of the Tax Court of Canada’s ruling that the Minister was correct in finding that the transactions between Marzen’s and its subsidiaries were not consistent with the arm’s length principle. (Marzen Artistic Aluminum v. the Queen, Can. Fed. Ct. App. No A-387-14, 2016)

The full text of the FCA’s decision can be found here

In its appeal, Marzen asserted that the Tax Court judge had erred in its application of the arm’s-length principle as defined under Subsection 247(2) of the Canadian Income Tax Act (“ITA”) and the Organization for Economic Cooperation and Development’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“OECD Guidelines”). The FCA found that Marzen did not provide any evidence of such an error by the Tax Court and held that Marzen’s appeal be dismissed “with costs.”

The Tax Court case related to the Minister’s reassessment of Marzen’s 2000 and 2001 taxation years in which the Minister made transfer pricing adjustments and assessed transfer pricing penalties with respect to the 2001 taxation year.

Marzen is a Canadian manufacturer of aluminum and vinyl windows. During the 2000 and 2001 taxation years, Starline Windows Inc. (“SWI”) was a related U.S. company selling windows manufactured by Marzen in the residential market in the U.S. Marzen became the sole shareholder in Starline International Inc. (“SII”), a company resident in Barbados and entered into a Marketing and Sales Services Agreement (“MSSA”) with SII to provide such services for the U.S. market. SII then subcontracted the provision of the marketing and sales services (along with other services covered by additional agreements) to SWI. SII compensated SWI on a cost plus basis; however, SII’s compensation from Marzen under the MSSA was much higher than SII’s payments to SWI.

In its reassessments of the 2000 and 2001 taxation years, the Minister disallowed Marzen’s deductions of any amounts paid to SII under the MSSA in excess of the fees SII paid to SWI. This resulted in disallowance of C$2,110,502 and C$5,025,190 in deductions for the 2000 and 2001 taxation years respectively. The Minister also found that the taxpayer had not made “reasonable efforts” to set and document its transfer pricing under Subsection 247(4) of the

ITA and therefore applied penalties in the amount of C$502,519 for the 2001 year as the adjustment amount had breached the penalty threshold.

The Tax Court had found that the terms and conditions of the MSSA were not arm’s length and that an arm’s length party would not have paid the fees charged by SII to Marzen during the 2000 and 2001 taxation years. In determining the adjustments to the MSSA fees, the Tax Court put forth that the first step in the analysis is to identify the transaction under review (i.e. the services provided under the MSSA).

The second step was then to assess the relative roles and functions of each entity. Based on this analysis, the Tax Court found that there was some minimal value added by SII that was incremental to the functions conducted by SWI and that therefore, Marzen could deduct the value of those incremental services. Using the Comparable Uncontrolled Price (“CUP”) method, SII’s services were valued at US$32,500 in each of the 2000 and 2001 taxation years. Although the revised adjustment for the 2001 year was now below the penalty threshold, the Tax Court nevertheless found that the taxpayer had not fulfilled the “reasonable efforts” standard under subsection 247(4) of the ITA.

The Marzen case is of particular interest to small and medium sized multinational enterprises (“SMEs”) as it demonstrates that the CRA’s scrutiny of tax structures and intercompany transactions is not limited only to large multinational enterprises (“MNEs”). With that said, the takeaways from the case are relevant to both SMEs and MNEs. Especially in light of the OECD’s work on the Base Erosion and Profit Shifting (“BEPS”) initiative, taxpayers should ensure their tax structures demonstrate sufficient substance and that intercompany transactions reflect arm’s length results. Intercompany agreements on their own cannot support transfer prices if there is no justification for the value associated with payments under those agreements. Furthermore, it highlights the need for taxpayers to demonstrate “reasonable efforts” to both set and document transfer prices in accordance with the arm’s length principle in order to avoid penalties in the event of a transfer pricing adjustment.

To learn more, contact Melinda Nguyen-Raybould at 416.515.3805 or [email protected], or your local MNP International Tax Advisor.