STEVAN NOVOSELAC: And welcome to this now our final session of our tax dispute resolution updates for 2023. These webinars were launched a couple of years ago now to present new Canada Revenue Agency policies as well as legislation and case law updates to help you to stay up to date with current developments in tax dispute resolution.
Please feel free to submit topics you would like us to discuss at future webinars, and you can also feel free to submit questions throughout today's session using the question feature there on Zoom. I'm sure you'll be familiar with. So please submit those at any point during today's session.
We're, again, aiming to wrap up by 12:30. However, after formally ending, for those who would like to stay on, we will continue for up to several minutes depending on how many questions come in to answer those. And if there are any questions that we don't get to, we will respond to you afterwards directly. Finally, please note by way of introduction that a copy of today's slides will be available online.
Being lawyers, we, of course, need to have a disclaimer. And while you can take a moment to read this on your screen, the essential message is that these webinars cover the topics presented only generally and are not intended to provide legal advice, since every situation is different and the law is always changing.
So for speakers for today, my name is Steve Novoselac. I serve as co-leader of Gowling WLG Tax Dispute Resolution practice in Canada. I'm joined today by two members of our firm's national tax practice group, Pierre Alary and André Bergeron, both from our Ottawa office.
Pierre is a member of our firm's Transfer Pricing and Competent Authority Group, where he assists clients with transfer pricing compliance and dispute resolution. In addition to transfer pricing, Pierre also defends tax payers at the audit and appeals stage for both domestic and international tax issues.
André practices in our firm's Transfer Pricing and Competent Authority Group as well. Prior to joining us, he was a senior economist for 10 years at the CRA's Competent Authority Services Division where he participated in advanced pricing arrangements and mutual agreement procedures with many foreign governments, as well as gaining extensive experience working on international transfer pricing audits.
For today in terms of topics, we have the following three. Number one, Canada's proposed digital services tax where things stand, which Pierre will be addressing, second, proposed administrative measures to simplify transfer pricing compliance in Canada, which André will discuss, and third, limitation period protects taxpayers from late reassessments, which I'll present. So Pierre with that, please go ahead and tell us about the proposed digital services tax.
PIERRE ALARY: OK, thank you, Stevan. So today, I'll be discussing Canada's new digital services tax, or the DST, which may come into force on January 1, 2024. So this new tax should have an impact on some of the largest corporations operating in the digital space.
In short, for corporations that are subject to this tax, the DST will impose a 3% tax on the in-scope digital services revenues earned from customers in Canada. Before we delve into the details, let's discuss some of the background to this legislation, some of which has caused some ripples in the international tax community.
So the first thing you need to mention is that the DST is intended to act as a contingency plan while global efforts to implement the Pillar One proposals from the OECD are underway. For more than 10 years now, the OECD has focused on cleaning up the international tax rules to ensure that profits are taxed where economic activities take place and value is created.
The OECD's base erosion and profit shifting project, referred to as BEPS, was delivered in 2015. The BEPS package of measures was considered to be the first substantial renovation of the international tax rules in almost a century.
To ensure a consistent and coordinated implementation of the BEPS recommendations, the OECD established the OECD G20 Inclusive Framework on BEPS in 2016. Addressing the tax challenges arising from the digitalization of the economy has been a top priority of the BEPS project and the inclusive framework.
At the request of the G20, the inclusive framework has continued to work on this issue. And in January 2019, members of the inclusive framework agreed to examine proposals in two pillars, which could form the basis for a consensus solution to the tax challenges arising from digitalization.
In July 2020, the G20 mandated the inclusive framework to produce reports on the blueprints of Pillar One and Pillar Two. Now, once implemented, Pillar One will impose a tax on digital services and it will apply to about 100 of the largest and most profitable multinationals.
It aims to allocate profits to countries where these companies sell their products or provide their services and ensures the multinational will pay income tax based on the location of the users and the customers.
So as you can see, the proposed DST in Canada aligns with certain principles under Pillar One by attempting to ensure that digital profits are taxed in jurisdictions where the users and the customers are located.
Once implemented, Pillar One is expected to replace digital services taxes currently in place around the world and eliminate the need for Canada to have its own digital services tax. However, the global efforts to implement Pillar One have taken a bit longer than expected.
On the Canadian side, the Canadian government first pledged to bring in a digital services tax on big tech companies back in 2020. The draft legislation of the DST was released in December 2021. But at that time, the Canadian government along with many other countries agreed to pause the implementation of its digital services tax in order to give time and space for negotiations on Pillar One.
In July 2023, many countries participating in those negotiations agreed to a further one year standstill on the imposition of any new domestic DSTs. However, the next day Canada announced that it would not support the extended standstill and that it would move forward with the implementation of its digital services tax effective January 1, 2024.
As you can imagine, this was a controversial decision which received a lot of criticism, namely from the United States. But it's easy to see why Canada was keen to move forward with its digital services tax. The Parliamentary Budget Office estimates that Canada's proposed DST could increase federal government revenues by $7.2 billion over the next five years.
In August of this year, Canada released the revised draft legislation of its DST. And two weeks ago, the government issued a new version of the DST legislation along with a digital services tax regulation that will pave the way for the implementation of the DST, but it did not specify when the tax will come into effect. So it is still unclear whether this tax will come into effect on January 1, 2024 or at a later time.
The DST is expected to have retroactive effect to January 1, 2022. So it will be interesting to see whether any delay in implementing the DST will change the retroactive effect date. Now, let's take a look at who will be affected by the DST.
First, the total revenue threshold requires that a taxpayer or the consolidated group it belongs to has earned revenues totaling 750 million euros or more in the preceding reporting calendar year from all sources. So this is about $1.1 billion Canadian.
Second, the Canadian in-scope revenue threshold dictates that a taxpayer or its consolidated group has earned Canadian in-scope revenues amounting to 20 million Canadian dollars or more within that calendar year. In-scope revenues will include the following, online marketplace services revenues, online advertising services revenue, social media services revenue, and Canadian user data revenue.
So online marketplace services revenue includes revenues derived from an online marketplace facilitating the interaction between vendors and customers. In other words, this targets companies like Amazon and eBay that provide an online marketplace where you will find many buyers and many sellers transacting with each other. These online platforms will usually charge some type of commission fee to process each transaction and that commission will be considered in-scope revenue.
Online advertising services revenue is generated through targeted online advertisements and digital space provision for such ads. Social media services revenue includes earnings from social media platforms facilitating user interactions and enhancements. So this charges platforms like YouTube, Twitter, and Instagram.
Finally, Canadian user data revenue. This includes income from selling or licensing user data collected from online marketplaces, social media platforms, and search engines. So if a taxpayer meets these thresholds, including having more than $20 million of in-scope revenue, this 3% tax will apply.
It will essentially apply on every dollar after the first $20 million of in-scope revenue. Because the DST legislation provides for a $20 million deduction, if the taxpayer is part of a consolidated group, the $20 million deduction will be allocated amongst the entities proportionately to their respective share of in-scope revenue.
Now, if the Canadian government moves forward with this legislation in the new year, then companies who are subject to the DST may be required to file returns for the 2022, 2023, and 2024 taxation years by June 30, 2025.
There is also a requirement to register for the DST. And this is very important. This requirement is triggered if you have in-scope revenues in excess of $10 million. So even though the tax is only triggered once you are in excess of $20 million, the registration requirement kicks in at $10 million.
And the registration deadline is January 31 of the subsequent calendar year in which you first met that $10 million threshold. Penalties for failing to register are $20,000 per year and penalties for failure to file will vary based on the duration of your non-compliance, but this could go up to as high as 17%.
So in conclusion, what taxpayers must do in the short term is to determine whether they have met either the 10 million or $20 million thresholds in a calendar year since the start of 2022. If so, they will need to understand the sourcing rules outlined in the legislation to help calculate the accurate amount of in-scope revenue.
Of course, this is all subject to the DST actually being enacted. And I assume that we will have an answer to that question fairly soon. And with that, I will hand things off to André.
ANDRÉ BERGERON: Thanks, Pierre. I think looking back, if we had to pick a poll question, one of them we'd put now is whether or not you think the government will actually go ahead with the DST by the end of the month.
So thank you, again, for joining us today, and good afternoon. So today, I'll discuss the recent changes to Canada's transfer pricing rules with a particular focus on some of the administrative measures that were proposed but have not, in my opinion, received as much airplay as the in-depth legislative changes.
So in a nutshell, the fall economic statement from the government of Canada confirmed that it intends to proceed with changes to Section 247 of the Income Tax Act. These changes were necessary following the recent decision in Her Majesty the Queen versus Cameco Corporation.
And along with the legislative changes proposed to deal with Cameco, Finance is also looking at updating various administrative elements, which are listed here, but I'll go through each one in the following slides.
So when the Cameco decision was delivered, it was evident that the lack of detail in the current rules specifically in how to apply the arm's length principle could lead to a wide range of interpretations by taxpayers and the courts alike.
So Cameco was the first Canadian case to consider the application of the recharacterization rule in subsections 247(2)(b) and (d). And upon losing the case, the end result in Cameco was that a significant amount of profits were taxed outside of Canada despite a perceived lack of functions performed in that other jurisdiction.
Finance Canada has acknowledged these concerns and has proposed changes be made to the subsections 247(1) and (2) of the act. And ultimately what that means is since Finance has an opportunity to open up the act to address these issues, they are now in a position to bring in changes to some of these administrative features that we were just discussing.
So what are these administrative measures proposed, which may have a more direct impact on your transfer pricing practices? Well, first up, Finance is integrating a consistency rule in Section 247 which will recognize the OECD transfer pricing guidelines into Canadian legislation.
So while already recognized as a source of guidance by Canadian companies and the CRA, the transfer pricing guidelines are not binding on Canadian legislation or jurisprudence. Therefore, it's similar to what's been adopted in other jurisdictions.
A consistency rule would require that domestic transfer pricing legislation be applied in a way that best secures consistency with the guidelines. So while this is a legislative change, it's extremely important from an administrative perspective.
Specifically until recently, OECD concepts could be contradictory to the CRA's internal policy or practice. And as an example, let's take the now canceled information circular 87-2R on international transfer pricing.
The information circular spoke to a hierarchy of methods, namely with the comparable uncontrolled price at the top versus the most appropriate method, which is what was stipulated in the OECD guidelines as of 2017.
So hence, for the circular transfer pricing report would first exclude the cup, then the resale price and the cost plus and then move on to the transactional methods. But per the guidelines, even if a cup is available, it may not be the most appropriate method. For example, you might need so many adjustments to your cup that it really doesn't reflect the reality of the company.
Similarly, recent initiatives of BEPS that were integrated into the OECD's transfer pricing guidelines are not necessarily in Canadian legislation either. So integrating this consistency rule means the government is indirectly endorsing the BEPS action items and encouraging everyone to comply.
Finance is also proposing amendments to transfer pricing documentation provisions. So the first of these measures includes the adoption of a standardized approach to documentation. So in Canada, many of the companies that we work with prepare the equivalent of a local file, and Finance is proposing to align current contemporaneous documentation requirements in subsection 4 with the local file requirements in chapter 5 of the guidelines.
There's also going to be the integration of a master file, which is a company-wide report prepared if the multinational enterprise generates 750 million euros. This would only have to be submitted to the CRA upon request. And for those who know, this threshold is consistent with the current country-by-country reporting rules.
So in addition, the government is considering provisions for lower risk transactions or involving smaller taxpayers. So under these circumstances, the transfer pricing documentation requirements could be simplified.
One option considered would allow the taxpayer to satisfy the transfer pricing documentation requirement by completing an annual reporting schedule. This could replace the need for a small taxpayer to complete contemporary documentation with all the requirements as stipulated in 247(4) of the act.
Ultimately, though, the government hopes to balance the CRA's need for timely, accurate, and relevant information to conduct risk assessments and efficient audits with its efforts not to impose excessive or unnecessary compliance burdens on taxpayers. And obviously, this is welcomed.
That said, there is still transfer pricing penalties if you fail to meet your obligations to make reasonable efforts. So despite all the measures that are proposed, whether it's a simplified approach or not, there's still a requirement to make efforts to identify an appropriate transfer price.
So under another proposal, Finance is proposing to adjust the current transfer pricing penalty provisions to correspond with modern inflation rates. So these haven't changed since the mid '90s. So as a result, the absolute threshold under the provision would be increased from 5 million to 10 million. However, the 10% relative threshold remains unchanged to encourage compliance amongst smaller taxpayers.
In the end, the key message is that everyone needs to make reasonable efforts to determine the transfer prices, whether it be through contemporary documentation or an annual checklist for smaller tax payers.
Finally, Finance Canada recognizes there are a number of situations where streamlined transfer pricing approaches can reduce compliance burden for taxpayers and ultimately, the number of transfer pricing disputes. One proposal is to streamline transfer pricing approaches for specific types of transaction.
The first example that was provided in the consultation report was with regards to low value adding intra-group services, such as accounting, human resources, and other similar services. In these instances, as opposed to running a comparative search, Finance would agree to allow companies to apply a cost plus 5% for these services. Coincidentally, this would be consistent with current OECD guidance.
A second example would be for distribution activities. As part of the OECD's Pillar One project, one proposal is to allow a 2% distribution margin for limited risk distributors. For many companies in Canada, this could prove to be a significant, as many foreign companies have distribution subsidiaries in Canada.
And finally, Finance is proposing a different approach with regards to intra-group loans. Of particular interest, Finance is recognizing a five-year term limit and allowing a company to use the multinational enterprises credit rating to determine the risk to the borrower.
In our practice, we've often supported companies in determining the standalone credit rating of the subsidiary and the applicable interest on a yearly basis based on that level of risk. So Finance's proposal would greatly facilitate compliance, reduce administrative burden for these transactions, and remove arbitrary assumptions on credit ratings and risk during the CRA audit. So thank you very much, and I will now pass it over to Stevan.
STEVAN NOVOSELAC: Thanks, André, for that excellent analysis. And so my topic is relating to limitation periods and how they protect taxpayers, and really commenting on a recent decision of the tax court that reiterated this protection that is afforded to taxpayers by the statutory limitation periods for the CRA to issue notices of reassessment.
The taxpayers in this case was called Tedesco had claimed losses for either their 2000 or 2001 taxation years, and these losses were entirely disallowed by the CRA. The tax court allowed the taxpayers appeals and vacated the CRA reassessments on the basis that their taxation years were statute barred. So that was the end result. And today, I'm going to discuss the background facts, explain how the tax court determined that the taxation years were statute barred, and finally offer some conclusions.
So in terms of the background facts, there were 14 individual taxpayers who were limited partners in what was named the TSI1 limited partnership. The individual taxpayers each claimed losses in the taxation years based on their interests in the partnership.
The partnership had claimed business losses in those years of some $941,000 in the first year and almost $2.2 million in the second year. So totaling over $3.1 million of losses. The losses claimed in turn by each of the individual taxpayers for the year ranged from $14,000 to $56,000, with losses claimed by all of them totaling over $516,000.
It's unclear how the remaining losses between the 3.1 million and the 516,000 that these individual taxpayers claimed, so that difference was about $2.6 million, it's unclear how those were treated and whatever happened to those.
At the outset of the hearing before the tax court, the taxpayers counsel advised the court that none of the issues which had been pled in the notices of appeal were going to be pursued other than whether the taxation years were statute-barred. Therefore, the taxpayers did not try to argue that the losses which had been claimed by the partnership were properly allowable.
It appears this may have been a difficult argument to successfully advance. This is because the CRA had previously disallowed the losses claimed by the partnership and the partnership had also appealed to the tax court.
The partnership however discontinued its appeal and it was accordingly deemed to be dismissed back in 2016. It's unclear why the partnership discontinued its appeal. In any event, after the partnership's appeal was dismissed, the tax court similarly made an order striking out the taxpayer's individual notices of appeal as well, thereby effectively ending their appeals.
The taxpayers appealed that decision to the Federal Court of Appeal and the appeal court allowed the individual tax court appeals to continue. This meant that the individual taxpayers were not prevented from advancing the statute barred argument on their appeals merely because the partnership had discontinued its own appeal.
The sole issue before the tax court accordingly ended up being whether the taxation years were statute-barred. Determining this issue turned on the dates the partnership filed its partnership information returns for each of the taxation years.
Specifically, subsection 152(1.4) of the Income Tax Act authorizes the minister of national revenue to determine the loss of a partnership for a fiscal period within three years after the day the partnership information return is filed for the fiscal period.
In this case, the minister sent a notice of determination to the partnership on March 29, 2006. The taxpayer's position was that the partnership information returns were filed for each of the taxation years in 2001 and 2002 respectively. They argued that since these dates were both more than three years before the March 29, 2006 notice of determination date, the taxation years were statute-barred.
The CRA's position, on the other hand, was that the partnership information returns were not filed until 2005, such that the notice of determination was made well within the three-year limitation periods.
Not surprisingly, conflicting evidence regarding the partnership information return filing dates was presented before the tax court. This extensive evidence was carefully considered and set out in great detail in the court's reasons for judgment.
The court observed that both parties faced challenges because of the lengthy history and passage of time, given that the hearing before the tax court was more than 20 years after the taxation years in issue. These challenges included hampering the witnesses ability to recall or clearly recall events and one witness being unavailable. And as well, there were documentary difficulties.
The tax court expressly preferred the testimony of the witness called on behalf of the taxpayers who essentially testified that the partnership information returns were hand delivered and thereby filed with the CRA.
The respondent's position was that the partnership information returns were not filed until 2005 at a meeting between the CRA officials and the taxpayer's witness. After considering and weighing all of the evidence on balance, the tax court found as a fact that the partnership information returns had been filed with the CRA on the dates in 2001 and 2002 as asserted by the taxpayers.
The court emphasized two main facts supporting this finding. First, there were copies of the two partnership information returns with the front pages apparently having been date stamped, quote, "received client services," end quote, by the CRA.
Second, there was a letter from the CRA dated in November of 2003 that appeared to confirm that the CRA had already received the partnership information returns. The letter stated and mentioned the returns and specifically stated that they had been provided.
So in conclusion, based on the factual finding that the March 29, 2006 notice of determination was dated more than three years after the partnership information returns were filed, the taxation years were statute-barred, the taxpayer's appeals were accordingly allowed, and the CRA's reassessments disallowing the losses from being claimed were all vacated.
The Supreme Court of Canada in the Markevich case has held that statutory limitation periods are meant to promote certainty, avoid stale evidence, encourage diligence, and bring repose. Therefore, taxpayers should only be stripped of their right to rely on statutory limitation periods in clear and compelling circumstances.
The reasoning and outcome of this case are therefore welcome, especially given the extremely long amount of time, over a decade, that it took for these appeals to circuitously wind their way along to the tax court hearing.
When it takes this long to get to court, the resulting extraordinary evidentiary challenges are entirely predictable and the proper application of statutory limitation periods becomes extremely important in cases like this.
So that concludes that topic. And on our next slide, you'll see we have a survey that we would ask you to please take a moment to scan that QR code and provide us with your feedback. We would certainly be most interested in your thoughts and your comments. And with that, thank you very much, again, for joining, and have a great rest of your afternoon.
However, as mentioned at the outset, while today's formal session is now concluded, we are going to continue with any of those of you who would like to stay on for a few minutes to address any questions that you could please put into the question feature.
All right, so in terms of questions, let's see. We have-- all right, we have a question dealing-- so when the appeal by the partnership, this pertains to my topic, when the appeal by the partnership was dismissed by the court, why weren't the appeals by the individual partners automatically dismissed since they dealt with the very same losses?
The partnership's appeal was discontinued. However, that could have been for any number of reasons. It doesn't necessarily mean that it was without merit. And of course, that the trite proposition that different taxpayers are each entitled to separate rights and can advance their own positions.
The individual partners were entitled simply to advance their statute-barred argument regardless of whether they could have been successful on the substantive merits of the case. That's really what that limitation period defense is designed to afforded that protection to taxpayers.
So the next question that we have relates to the DST. So it's for Pierre. Will there be differences in how the DST applies to Canadian companies versus foreign companies?
PIERRE ALARY: Right. So yeah, the DST definitely applies to foreign companies, but their status as a non-resident may actually change the way that certain parts of the legislation applies, for instance, for the sourcing rules.
So if you have a Canadian vendor and a Canadian customer, then the entire commission fee will be included as in-scope revenue. However, if you have a non-resident vendor and Canadian customer, then only half of that dollar is going to be included in the calculation of in-scope revenue for this vendor.
So yeah, there are some differences definitely. And again, we haven't seen the enactment of the legislation. So it'd be important to look at the final product. But yeah, there will be differences for sure. So be careful when you're looking at the sourcing rules to see how the legislation will apply to your particular company or client.
STEVAN NOVOSELAC: All right, thanks, Pierre. There's another question here pertaining to the reassessment periods. It says, CRA seems to be reassessing outside limitation periods now. Do you have any advice how to deal with this?
So that is certainly something that we've seen where auditors will not be hesitant and oftentimes to raise reassessments, even though they are applying to years that are beyond the limitation period. And every file is different. So you have to consider each situation, of course, on its own.
Having said that, we have found that a limitation period argument can get traction or perhaps even more traction with an appeals officer. So once the objection is filed and you're dealing with an appeals officer, that is certainly when that argument can be advanced. And we've seen good success at that time with that being advanced at that stage.
PIERRE ALARY: Yeah, I would add there's a lot of case law on this subject. And if you make case law representations with an auditor, it might not get you very far. But with an appeals officer, they tend to really consider your representations much more. So that's why I agree with Stevan that the chances are better for you to overturn these assessments on the 152 for limitation argument at the appeal stage.
STEVAN NOVOSELAC: Yeah, that's exactly right. And even I'll layer onto that and even say that any argument that is more in the nature of a legal argument can tend to get sometimes better reception at that stage as well. All right, so next question. Will there be an obligation to follow the safe harbor provisions for intra-group services or distribution activities? So that would be for André, please.
ANDRÉ BERGERON: Yeah, that's a great question because on the one hand, CRA and the OECD as a whole is encouraging companies to conduct their functional analysis and identify what the results should be. But then there's a recognition that we have these safe harbor rules that would provide a little bit of a minimum if you want.
But ultimately, what it comes down to is CRA will look at every situation for what it is. And if you've got-- let's use the intra-group services as an example, a cost plus 5%. If you are paying that out to a company in the United States for HR services and you're paying 5%, you should be OK. If you're paying below that, CRA is not going to complain with a lower markup going to the US.
However, when you start going above the 5%, that's where your functional analysis will have to show what they are doing in the US is actually worth it in that industry and those economic circumstances.
The flip side is true also for the distribution margin. 2% has been floating around both at the Pillar One level and we've indirectly heard it here with the CRA. But ultimately, if you decide to leave a distribution margin of 3% in Canada, nobody at the CRA is going to say the opposite of that.
Where it's going to get interesting is if you have a distribution margin that is below the 2%. What are you going to do with that, and how do you validate that in your contemporaneous documentation? And again, the 2% on 1 million is much different than 2% on 10 or $100 million, right?
So ultimately, there's not going to be an obligation to follow these provisions, but it's going to indirectly set some level of threshold that if you don't meet it, I anticipate the CRA will ask more pointed questions.
STEVAN NOVOSELAC: All right, thanks very much, André. And there don't appear to be any further questions at this point. So we can wrap up. And thank you, again, very much for taking the time to participate in this session, and have everyone have a wonderful holiday season. Bye-bye.