By judgment rendered on September 26, 2018, Owen J of the Tax Court of Canada held in favour of Cameco Corporation ("Cameco") in respect of a transfer pricing dispute covering Cameco's 2003, 2005 and 2006 taxation years (the "Decision"). The dispute dealt with the marketing and trading structure between Cameco and related foreign subsidiaries involving uranium trades. The reassessments added nearly $500 million to Cameco's income for the taxation years, with even greater potential exposure looming over Cameco with respect to later years. The government has appealed the Decision to the Federal Court of Appeal ("FCA").
The Facts
In 1999, the Cameco group reorganized its uranium transactions so that uranium produced by Cameco and other suppliers would flow through a Cameco-controlled Swiss trading company ("CEL"). CEL then sold the uranium through a related U.S. marketing company to third party customers. The Canada Revenue Agency ("CRA") took exception with CEL's lack of functionality as it had only 1 or 2 employees at any time. The CRA reassessed Cameco on the basis that: i) the transactions were a sham; ii) the transfer pricing re-characterization rules in paragraphs 247(2)(b) and (d) were applicable; and iii) in the alternative, the general transfer pricing provisions of paragraphs 247(2)(a) and (c) were applicable.
The Decision is inconsistent with the Organisation for Economic Co-operation and Development's revised transfer pricing guidelines ("OECD Guidelines") arising from its ambitious initiative to counter base erosion and profit shifting ("BEPS Project"). The Decision supports that proper tax planning can still be used to shift profits to lower tax jurisdictions and puts into question, at least in Canada, the application of the revised Guidelines.
Sham Argument
Despite the Crown's allegations that Cameco, for all intents and purposes, ran the business of CEL, the Court ruled that there was no deception or sham and that CEL's profits resulted from its bona fide trading activity. It was concluded, unsurprisingly, that the arrangements created by the contracts were not a façade and that tax motivation is not a basis to transform such arrangements into a sham. In hindsight, it was a strategic mistake for the Crown to raise a sham argument rather than focusing its efforts on the transfer pricing issues. The Crown seemingly acknowledged as much by not raising the sham argument in its FCA appeal.
Re-characterization Rules
The re-characterization rules generally apply when transactions are commercially irrational and cannot be priced under the arm's length principle ("ALP"). Given the difficulty in establishing that a transaction is commercially irrational, the CRA generally makes transfer pricing adjustments based on the ALP. Owen J, consistent with how courts generally approach anti-avoidance provisions, interpreted the rules narrowly and found that the transactions were commercially rational. The Decision, which is the first Canadian jurisprudence on how to apply the re-characterization provision, provides useful guidance on several aspects of these rules for the Canadian tax community.
Arm's Length Principle – How to Weigh Functions, Assets and Risks
The OECD's BEPS Project and revisions to the Guidelines arguably changed the ALP from a balanced approach involving the analysis of functions, assets and risks, to a weighted approach where important decision functionality is given more weight than legal ownership of assets and contractual assignment of risk. Canada has endorsed the new Guidelines, which it describes as clarifying in nature and not a fundamental change to the ALP.
The Decision contradicts the new OECD approach. For example, Owen J accepted one expert's opinion that "The key point is that it is the owners of the asset who bear the asset's risk, not the managers of that risk" and accepted that certain value added managerial functions can be properly compensated as routine services. If the Decision is upheld by the FCA, this will establish a precedent that seriously jeopardizes the potential impact of key elements of the BEPS Project in Canada, notably with regards to value-creating functions related to the development, enhancement, maintenance, protection and exploitation of intangibles.
Key Issue which the Decision Fails to Address
The comparable uncontrolled price ("CUP") method provides the highest degree of comparability, provided that none of the differences between the transactions being compared could materially affect the price in the open market. Where possible, reasonably accurate adjustments must be made to eliminate the material effects of such differences.
In our view, the guarantee provided by Cameco to CEL on its third party purchases was a material contractual difference between the CUPs presented by Cameco's experts and the Cameco-CEL transaction. When dealing at arm's length, a uranium miner such as Cameco would not sell uranium under long term contracts to a party that is unable to provide assurances that long term obligations will be met in the event the uranium market drops. Based on the Decision, it appears that the Crown's experts failed to note that, unlike the third parties, Cameco had no purchase guarantees on its sales to CEL.
Cameco's experts pointed out that CEL contractually assumed the price risk. However, without Cameco's purchase and finance guarantees, CEL would not have had the ability to assume this risk. This fact was made clear when a party to the negotiations of one of the key CUP contracts testified that: "the [third party vendor], having had some bad experiences with bankruptcies and subsidiaries, said….use whatever Cameco subsidiary you want, but just make sure we get a Cameco guarantee because we want to know that Cameco, the corporation, is standing behind this." Therefore, in our view, based on this material contractual difference, the CUPs should have been deemed inappropriate, as reliable adjustments to account for the lack of guarantee in the tested transaction would be difficult, if at all possible, to be made.
Closing Comments
This case highlights the potential complexity of non-ALP transfer pricing arguments. Rather than argue the commercial irrationality of the transactions, the Crown should have focused on the terms and conditions of the Cameco-CEL transactions and the inadequate compensation received by Cameco. In our view, the Crown erred by fixating on substance over form, the 1999 reorganization, and the assignment of certain contracts. Many of the Crown's arguments were arguably lost on the wrong transactions. By introducing so many arguments, we believe the Crown muddied the waters instead of targeting the following two fundamental issues:
- Cameco's compensation for guaranteeing CEL's third party purchases: the Court stated that "Cameco guaranteed CEL's performance under the third party contracts and indirectly provided financing to CESA/CEL. However, CRA has not attributed a specific value to these particular services. Accordingly, there is no evidence on which to base an adjustment for these services even if one were warranted." Proper valuation was never performed by CRA and may have shifted some profits back to Cameco.
- Cameco's compensation for its sales to CEL: The Crown failed to argue that the CUPs lacked all the elements of comparability required to evaluate the price of the sales by Cameco to CEL. The main comparability difference relate to the guarantees provided by Cameco in the case of the CUPs, given that no such guarantees were provided for the tested transaction. This material difference in contractual terms would likely have disqualified the CUPs.
The Court's analysis of the ALP is fundamentally different than the new guidance from the OECD. This should be concerning to the Canadian tax community because Canada will likely continue to negotiate mutual agreement procedure ("MAP") settlements in a manner consistent with the revised OECD Guidelines. Even if the FCA upholds the Decision, CRA auditors and the Canadian competent authority will presumably attempt to distinguish it based on its unique facts. Therefore, if taxpayers want an independent review of their legally effective but tax motivated structure, based on judicial precedent, they may need to consider bringing their case before CRA Appeals, and then, if necessary, to Court. This may carry a significant cost to taxpayers.
Some opponents of the ALP will likely view the Decision as further evidence that the preferred approach to transfer pricing is a formulary one. The release of the Decision, which contradicts certain fundamental recommendations of the BEPS Project, despite the significant time and effort invested by the OECD and world governments since 2012, suggests there may be some merit to considering a new approach to transfer pricing and tax sharing between governments. However, the OECD would likely not consider implementing a change of such magnitude absent a spate of global court decisions along the lines of Cameco. As an alternative course of action, assuming the Decision is upheld by the FCA, the Canadian government may have to give due consideration to somehow codifying the new Guidelines into its tax legislation or introducing revisions to its controlled foreign affiliate legislation to include certain low or no-taxed foreign active business income as FAPI.