The Sifto decision - is the minister bound by MAP settlements?

This article was originally published in Bloomberg BNA Transfer Pricing Report, and has been republished with permission.

On March 10, 2017, the Tax Court of Canada ("TCC") delivered its decision in Sifto Canada Corp. v. The Queen¹ regarding the legal effect of a transfer pricing settlement reached under the Mutual Agreement Procedure Article ("MAP Article") of the Canada - United States Tax Convention ("Treaty"). In Sifto, Justice Owen overturned the Canada Revenue Agency's ("CRA") transfer pricing adjustment on the basis that the CRA was bound by an earlier MAP settlement, which established the arm's length values of the intercompany transactions in question.

The Sifto case involved a unique situation where the CRA transfer pricing adjustments that were the subject of the MAP settlement arose as a consequence of a voluntary disclosure. Subsequent to the voluntary disclosure and MAP settlement, the CRA conducted an audit of the same taxation years and raised transfer pricing adjustments. The CRA's ability to issue reassessments resulting from this subsequent audit was the issue under appeal in Sifto. This article examines the conclusions reached by the TCC regarding the legal nature of the agreements (i.e., MAP settlements) and the comments provided by CRA regarding its views on the nature of a transfer pricing MAP settlement and its role in the MAP process.

Regarding section 115.1 of the Income Tax Act (Canada) ("ITA"), in obiter Justice Owen seemed to expand the scope of that provision beyond what some, including the authors, considered its intended application. Finally, the Sifto case serves as a bit of an eye opener, not only with respect to the lack of due diligence undertaken by the CRA in its handling of this file, but to some long standing deficiencies in Canada's transfer pricing dispute resolution system.

Summary of the Sifto Decision

Facts

The facts were straightforward:

• In 2007, under the CRA's Voluntary Disclosure Program ("VDP"), Sifto reported to CRA for the taxation years 2002 to 2006 that it had under-reported its taxable income by approximately $15.81 million, $13.34 million of which related to transfer pricing.
• As a consequence of an internal revised transfer pricing report ("Revised TPR"), Sifto recognized that with respect to its sales of rock salt to North America Salt Company ("NASC"), a company that is a resident of the U.S and that does not deal at arm's length with Sifto, it had under charged NASC for the salt and, therefore, under-reported its taxable income in Canada during those years.
• The CRA's VDP team, without any substantive audit activity and without forwarding the voluntary disclosure to the areas within CRA with transfer pricing expertise, accepted the revised transfer prices as per Sifto's Revised TPR.
• As a result of the voluntary disclosure, notices of reassessment were issued in 2008 ("2008 Reassessments") to include Sifto's upward adjustments.
• Upon receipt of the 2008 Reassessments, Sifto and NASC were now in a position of economic double taxation. Both companies then proceeded under the MAP Article of the Treaty to request their respective competent authorities to resolve the matter of double taxation.

As the MAP process ran its course, the U.S. and Canadian competent authorities ("USCA" and "CCA", as the case may be), through an exchange of letters, reached a settlement ("MAP Settlement Agreement"). In brief, the USCA agreed that it would provide correlative relief in accordance with its obligations under paragraph 3 of Article IX of the Treaty with respect to the full amount of the transfer pricing adjustments raised in the 2008 Reassessments. In other words, the USCA agreed to reassess the relevant U.S. tax returns² to decrease the reported income by a corresponding amount. As is normal procedure following a MAP Settlement Agreement, through another exchange of letters between Sifto and the CCA, Sifto agreed to the terms and conditions of the settlement ("Sifto-CCA Agreement").

In 2012, the CRA Audit Division ("CRA Audit"), after an audit of Sifto's 2004 to 2006 taxation years, raised further upward transfer pricing adjustments ("2012 Reassessments") in respect to the same intercompany transactions that were the subject of the MAP Settlement Agreement and Sifto-CCA Agreement (i.e. the sale of rock salt from Sifto to NASC) totalling approximately $135 million. Sifto ultimately filed notices of appeal to the TCC to appeal the 2012 Reassessments.

Parties' Submissions

Counsel for Sifto argued that the Sifto-CCA Agreement was a binding settlement agreement that established the arm's length transfer price for those intercompany transactions and prohibited the CRA from raising subsequent transfer pricing adjustments with respect to the 2002 to 2006 transactions. Sifto also argued that the Sifto-CCA Agreement was enforceable against the Minister by virtue of both the Treaty and subsection 115.1(1) of the ITA.

The Crown's arguments can be summarized as follows:

• The letters which formed the MAP Settlement Agreement "do not reference a transfer price for the salt sold by the Appellant to NASC during the [2004 to 2006] Taxation Years and do not represent an agreement between the CCA and USCA on the arm's length transfer price of that salt".³
• The letters exchanged by the CCA and USCA represented a mutual agreement under the Treaty to provide relief solely from double taxation and, therefore, did not preclude the Minister from issuing the 2012 Reassessments by virtue of such agreements. In other words, regardless that the USCA and CCA need to arrive at an agreement on the transfer price within the bilateral MAP process, the agreed upon transfer price is only in the spirit of providing relief from double taxation and is not a concession that the agreed transfer price is fully in accordance with the arm's length principle.
• The Sifto-CCA Agreement, in and by itself, does not constitute a settlement agreement between the Minister and Sifto fixing the transfer price of the salt as it was just a standard exchange of closing letters between the CCA and Sifto with no "intention to create a binding contractual relationship". That is, there was no consideration, no certain terms and no communication of an intention to fix the transfer price in those closing letters.
• Even if the MAP Settlement Agreement and the Sifto-CCA Agreement resulted in a binding contract between the Minister and Sifto, the Minister had a duty to administer and enforce the ITA and was duty-bound to issue the 2012 Reassessments.

Decision

With respect to the issue of whether the Sifto-CCA Agreement was a settlement agreement fixing the amount of the transfer price, the TCC undertook an analysis of the general law on settlement agreements and concluded that the Sifto-CCA Agreement was a settlement agreement. The TCC was convinced that there was evidence of mutual intention, mutual consideration and certainty of terms and reached a conclusion that the Sifto-CCA Agreement was a settlement agreement regardless of the procedural informality of the letters exchanged between the parties.

Once the TCC established that the Sifto-CCA Agreement was a settlement agreement, it turned its attention to whether the Minister was still required to reassess Sifto notwithstanding the settlement agreement otherwise establishing the transfer price for those transactions. In this regard, the TCC focused on three main questions:

1. Is the Sifto-CCA Agreement binding on the Minister so as to prohibit her from reassessing contrary to it?
2. If the Sifto-CCA Agreement is not binding on the Minister, is the Minister not otherwise bound by the Treaty as a consequence of the MAP Settlement Agreement being reached?
3. If the MAP Settlement Agreement is not binding on the Minister by the operation of the Treaty and its implementation statute, what effect does subsection 115.1(1) of the ITA have on the Minister's right to override the MAP Settlement Agreement?

After an analysis of the jurisprudence⁴ regarding whether settlement agreements are binding on the Minister, Justice Owen found "no basis on which to conclude that the agreement reached by the CCA and the USCA and accepted by the Appellant and Compass was indefensible on the facts and the law".⁵ Consequently, the TCC concluded that the terms of the Sifto-CCA Agreement were "binding on the Minister and the Appellant as a settlement agreement" and that those terms "fix the income of the Appellant from the transactions with NASC during the Taxation Years".⁶

The TCC also came to a similar conclusion regarding Sifto's alternative arguments on the operation of the MAP Article. After analysing the Treaty, the Vienna Convention and the Canada-United States Tax Convention Act ("CUSTCA"), the latter of which specifically gives the Treaty the force of law in Canada, the TCC concluded that the "Minister has breached Canada's obligations under the Convention by failing to give continuing effect to MAP agreements reached with the United States under paragraph (2) of Article XXVI of the Convention".⁷ The "issuance of the Reassessments is subject to subsection 3(2) of the CUSTCA and to Article 27 of the Vienna Convention, which afford paramountcy to the provisions of the Convention".⁸ The Minister was then ordered to vacate the 2012 Reassessments.

Lastly, Justice Owen concluded that subsection 115.1(1) is of no assistance in this case because, even if it applies, it does not go so far as to address the Minister's ability to issue the 2012 Reassessments. However, in what appears to be obiter, Justice Owen concluded that the Sifto-CCA Agreement was an agreement otherwise described in subsection 115.1(1) of the ITA and therefore all determinations made in accordance with the terms and conditions of that agreement were deemed to be in accordance with the ITA.

Analysis and Takeaways

This is an interesting case for many reasons. First, it is the first Canadian tax case dealing with the legal impact of a MAP settlement on the ITA as well as the legal nature of the acceptance of a MAP settlement by a taxpayer. Second, this decision could have some far reaching ramifications with respect to non-transfer pricing cases due to the comments given by Justice Owen in obiter regarding section 115.1 of the ITA. Finally, the case highlights some questionable errors in judgment made by the CRA's VDP and the CCA as well as pitfalls in Canada's transfer pricing dispute resolution system which taxpayers must be aware of when deciding whether to contest a transfer pricing adjustment by either filing a competent authority request under the MAP Article or a notice of objection to be reviewed by the CRA Appeals Directorate ("CRA Appeals").

General Comments

At the outset, it is important to recognize that this was a highly unusual case for the CCA. Most MAP requests pertaining to transfer pricing reassessments of a Canadian corporation are made as a consequence of CRA-initiated audit activity. In other words, reassessments are generally only raised following a full-scale transfer pricing audit. In Sifto, as reassessments arose as a consequence of a voluntary disclosure, no review of the taxpayer's transfer pricing analysis was undertaken by anyone within the CRA. This is a sensitive case for the CRA because it believes that it did not have a proper opportunity to review the taxpayer's transfer pricing position.

In normal transfer pricing cases, it would be relatively unheard of for CRA Audit to audit the same intercompany transactions twice for the same taxation years. The authors of this article have worked in the CCA and are not aware of any scenario where a MAP settlement was reached only to have the CRA subsequently re-audit the same intercompany transactions for those MAP settlement years. If such a situation had occurred, the CCA would have likely intervened to persuade CRA Audit against raising new reassessments, not on the basis of the MAP settlement being binding on the Minister, as the TCC ruled in Sifto, but rather for reasons relating to duplication of resources, relationship issues with the foreign competent authority, fairness (e.g. Taxpayer Bill of Rights issues) and common sense.

Legal Impact of a MAP Settlement

The CCA officers who testified before the court were of the view that the letters exchanged by two competent authorities in finalizing the MAP process represent a mutual agreement under the Treaty only to provide relief from double taxation and do not represent an agreement on the arm's length transfer price. The TCC did not agree with this line of argument and concluded that an agreement had in fact been reached on a transfer price and that such transfer price was binding on the Minister. That is, the two competent authorities, in order to resolve double taxation, must first negotiate and agree on a transfer price that both jurisdictions will accept for purpose of its resident's tax returns. It is the process of having both taxing jurisdictions reach an agreement on a single transfer price, whether that agreed-upon transfer price is principled or not⁹, that effectively relieves double tax. One can understand why the TCC reached the conclusion it did.

However, notwithstanding the TCC's analysis in support of its decision, and the fact that many in the tax community would agree with the decision, we would have preferred to see some discussion by the court regarding the relevance, if any, of paragraph 2 of Article XXIX of the Treaty (the "Saving Clause") on this case. The Saving Clause states that "Except to the extent provided in paragraph 3, this Convention shall not affect the taxation by a Contracting State of its residents..."^[10] The exceptions to the Saving Clause that are listed in paragraph 3 of Article XXIX, with respect to Article IX, only make reference to paragraphs 3 and 4 of Article IX (i.e. the correlative relief provisions). In other words, due to the Saving Clause, an argument could have been made that the Treaty, notwithstanding that there was a MAP settlement establishing the amount of correlative relief to be given, cannot impact a Contracting State's right to raise a transfer pricing adjustment (e.g. the 2012 Reassessments) on its own resident provided the adjustment was in accordance with the arm's length principle described in paragraph 1 of Article IX of the Treaty.

One issue not discussed in Sifto is how these MAP agreements affect a taxpayer's objection and appeal rights where the taxpayer has not specifically waived its objection and appeal rights¹¹. This is of particular interest given that it is the CCA's recently adopted policy to require taxpayers to waive such rights before it will finalize the MAP settlement.

Subsection 115.1(1) of the ITA

Section 115.1 of the ITA was initially introduced to allow the CCA to enter into an agreement to defer Canadian tax pursuant to certain prescribed tax treaty provisions (e.g. Article XIII(8)¹² of the Treaty was one of the initial treaty provisions prescribed). Section 115.1 was amended in 1994 to extend its application to a broader range of transactions. In this regard, in obiter Justice Owen indicated that the Sifto-CCA Agreement would constitute an agreement otherwise described in section 115.1 and consequently "subsection 115.1(1) deems all determinations made in accordance with the terms and conditions of the MAP agreements to be in accordance with the ITA".¹³ Admittedly, the language in section 115.1 is fairly broad and applies where the "Minister and another person have, under a provision contained in a tax convention or agreement … entered into an agreement with respect to the taxation of the other person".¹⁴ However, it is not clear whether the 1994 amendments were intended to be interpreted this broadly. It is arguable that new subsection 115.1(1) was intended to accommodate only those provisions in a tax treaty that provide specifically for a different tax treatment than that provided for under the ITA. Examples of these specific types of treaty provisions, in addition to Article XIII(8) type provisions, would include Article XXIX(5)¹⁵ and XXIXB(5)¹⁶ of the Treaty. In other words, it is not clear whether subsection 115.1(1) is intended to grant the CCA the authority to enter into agreements under their general powers under the MAP Article allowing, in order to resolve double tax, a different tax treatment than that otherwise allowed under the ITA. In the absence of a very specific provision in the treaty authorizing such different tax treatment with taxpayers, these far reaching powers are normally reserved for Parliament.

An explanation of the possible ramifications of such a broad interpretation of section 115.1 goes beyond the scope of this article. However, if the CRA accepts the TCC's comments on section 115.1, the CCA would arguably have a very broad empowerment to resolve double tax cases due to the interaction of the MAP Article and section 115.1 of the ITA. For example, specific relieving rules in tax treaties, such as Article XIII(8), may no longer be needed if the CCA is empowered to agree to resolve double tax any way it sees fit under the general powers of the MAP Article.

From a transfer pricing perspective, and again only to serve as an example of the possible ramifications of the TCC comments regarding section 115.1 of the ITA, the CCA would seem to now have a legal basis to revisit its policies on telescoping.¹⁷ For example, we understand that the CCA currently does not allow telescoping because it is not a principled resolution approach consistent with subsection 247(2) of the ITA. It would seem an argument could now be made that the CCA is empowered, in the form of a MAP settlement, to arrive at transfer prices on a year by year basis in any manner it sees fit and that such agreements would be considered to be in accordance with the provisions of the ITA.

CRA's VDP

In Sifto, the CRA's VDP arguably acted irresponsibly in accepting the taxpayer's transfer pricing analysis without referring the file to an area within CRA with the expertise to conduct its own transfer pricing analysis. The CRA, presumably as a consequence of the Sifto case, has in the last couple of years amended its voluntary disclosure policy to provide that transfer pricing cases will not be accepted without first being reviewed by CRA Audit.¹⁸ Regardless, tax administrations have been aware of the issues regarding self-initiated transfer pricing adjustments for years. This begs the question as to why the CRA's VDP did not have a policy in place on transfer pricing matters prior to this recent change in policy.

In spite of the recent policy changes to the CRA's VDP, it is still an option for taxpayers concerned about possible transfer pricing penalties. However, there are some issues to consider before initiating a voluntary disclosure. For example, if CRA Audit were to determine that the revised transfer price in the voluntary disclosure is still understated and further upward adjustments are needed, it is not clear whether the CRA would grant full, or even partial penalty relief under the VDP. The absence of CRA guidelines on its VDP in respect to transfer pricing cases has resulted in much uncertainty in the tax community. Adding to this uncertainty is a recent recommendation in the Offshore Compliance Advisory Committee's Report on the VDP that the VDP should not be made available for companies seeking relief in respect to related party transfer pricing issues, including transfer pricing penalties. No announcements have been made by CRA whether or not this recommendation will be implemented.

The Sifto case highlights the importance of seeking experienced tax counsel where transfer pricing discrepancies are identified in filed tax returns. For example, in the event there was any merit to CRA's $135 Million 2012 Reassessment, the decision made by Sifto to utilize the CRA's VDP to rectify its transfer pricing discrepancies worked out quite favorably.

Did the Canadian Competent Authority Manage the Sifto File Correctly?

The CRA should have undertaken a review of the merits of the taxpayer's transfer pricing analysis before entering into bilateral negotiations with the USCA. The file's unorthodox path from the VDP to the MAP program should have alerted the CCA that some due diligence was required at the early stages of the MAP request. However, the CCA's dilemma is that their role is to resolve double taxation and not carry out an in-depth review or audit of the transfer pricing analysis that was used in support of the reassessment. The latter point is a sensitive issue among competent authorities where the competent authority in the state where the transfer pricing adjustment was raised enhances or improves the auditor's analysis/arguments as per the auditor's transfer pricing report which is the basis for the adjustments that are the subject of the MAP request. Having said that, the CCA would normally undertake some form of due diligence at the preliminary stages of the MAP request to ensure the transfer pricing adjustments appear principled and consistent with the arm's length principle. It is not uncommon for the CCA to unilaterally reverse a transfer pricing adjustment without entering into bilateral negotiations with the other competent authority where they find the adjustments unprincipled or unsupported. This approach is consistent with paragraph 2 of the MAP Article in the Treaty, which states that:

"The competent authority of the Contracting State to which the case has been presented shall endeavor, if the objection appears to it to be justified and if it is not itself able to arrive at a satisfactory solution, to resolve the case by mutual agreement with the competent authority of the other Contracting State…"¹⁹

[emphasis added]

The CCA's actions in this case seem slightly out of character if they indeed failed to undertake a cursory review of Sifto's transfer pricing analysis.

Regardless of the rationale behind the CCA's decision not to review the merits of Sifto's transfer pricing analysis, once the CCA learned that the intercompany transactions that were the subject of the MAP request were under audit by CRA (which the CCA were made aware of prior to reaching a MAP settlement with the USCA) it should have been more assertive in either:

1. delaying the MAP negotiation process to allow CRA Audit time to expedite a reassessment prior to it concluding a MAP settlement with the USCA or prior to the arbitration time period kicking in; or
2. convincing CRA Audit to cease audit activity for those years about to be covered by a MAP settlement agreement.

CRA's Testimony in Sifto Highlight Deficiencies in the Dispute Resolution System

In its testimony to the TCC, the CCA was clear that, in their view, a MAP agreement on transfer pricing cases does not represent an agreement between the two competent authorities on the arm's length transfer price. Even though the Sifto case involved a unique situation involving an assessment arising from a voluntary disclosure, many of the comments provided by the CCA were with respect to their role and mandate under the MAP process in general. The CCA's understanding of the MAP process was that, regardless of the need to agree on a transfer price within the bilateral MAP process, the agreed upon transfer price is only in the spirit of providing relief from double taxation and is not necessarily an acknowledgment that the agreed transfer price is fully in accordance with the arm's length principle. These comments by the CCA should remind taxpayers of certain traps in Canada's current transfer pricing dispute resolution system.

It is the CCA's current policy that when a MAP request has been made and notices of objection have been filed on the same transfer pricing issue, which is the normal process in a transfer pricing dispute, the taxpayer must request that the notices of objection be held in abeyance pending resolution of the MAP process. This wisely avoids a duplication of efforts by two CRA dispute resolution teams. If a MAP settlement is reached and the Canadian taxpayer agrees to the terms and conditions of the MAP settlement, it is generally understood that CRA Appeals will not revisit the matter. In most cases, there would be no need for CRA Appeals to review the matter further. However, in some cases, Canadian taxpayers place more importance on arriving at the proper taxable income figure than resolving double taxation. Such could be the case where transfer pricing penalties have been assessed, the related company in the other country is in a loss position, or the Canadian tax rates are higher than rates in the other country.

The lack of independent review by the CCA on the merits of a transfer pricing adjustment, which the CCA has indicated in Sifto is not part of its mandate, is troublesome when you consider that taxpayers are, for all intents and purposes, being forced to forfeit their right to a legitimate independent review of the merits of the transfer price adjustment (i.e. by CRA Appeals or a Canadian court) once the taxpayer decides its primary objective, or necessity, is to avoid double taxation. For example, if a taxpayer chooses to first proceed to CRA Appeals, and if the taxpayer concurs with the final CRA Appeals decision, it is the policy of the CCA that it "will only present [the case] to the other competent authority and will not negotiate the issue a second time".²⁰ The same policy applies to Canadian court decisions. In other words, the taxpayer has no guarantees of full relief from double taxation if it opts to exercise its objection or appeal rights first. As the objectives of the competent authorities are solely to resolve double tax, there are many scenarios where the MAP settlements will not reflect transfer prices that CRA Appeals or a Canadian court would arrive at following a true independent review of the arm's length principle.

Transfer Pricing Penalties

To further illustrate the concerns alluded to above, consider transfer pricing penalties. When penalties are assessed in transfer pricing cases, and a MAP request has been filed to resolve double tax, it is the CCA's policy not to review the penalty. This is because tax treaties do not deal with penalties and, consequently, the CCA has no jurisdiction on those matters. Transfer pricing penalties generally involve a two-step process. First the adjustments must meet a certain dollar threshold to trigger the penalty. Second, once the dollar threshold is met and penalties potentially apply, there is a "reasonable efforts" defense in respect of the taxpayer's efforts to have properly documented the transaction. Once a MAP settlement has been reached, and the agreed transfer price still meets the dollar threshold to create the penalty, the question of how to dispute the penalty arises. The taxpayer, having properly filed a notice of objection, would ask CRA Appeals to review the penalty. Problems will arise because it is CRA Appeals' policy not to review the amount of the arm's length transfer price as agreed upon by the two competent authorities under the MAP settlement, even if that review of the arm's length principle is strictly in the context, or the objective of, having the penalty overturned. CRA Appeals will only review the merits of the taxpayer's "reasonable efforts" defense. This creates an issue because the amount of the penalty is determined based on the amount of the transfer pricing adjustment. Therefore, in the context of transfer pricing penalties, taxpayers are sometimes forced to forgo their right to resolution of double tax if they want their transfer pricing penalty to receive a full principled independent review under both avenues of defense (dollar threshold and reasonable efforts).