Start. So welcome to our 10th session of our Tax Dispute Resolution Monthly updates. While this is our final session for this year, please watch for our invitation to the next session in the new year. Being lawyers, we of course need to, as we always do, start with a disclaimer. While you can take a moment to read this, 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. My name is Steve Novoselac and I serve as co-leader of Gowling WLG's Tax Dispute Resolution practice in Canada. I'm joined today by two members of our firm's National Tax practice group, Pierre Alary and Lesley Kim. Pierre specializes in resolving tax disputes along with transfer pricing issues and works out of our Ottawa office. Lesley practices out of our Calgary office and has wide-ranging tax expertise including tax dispute resolution. These webinars, as regular attendees will be aware, present new CRA policies, legislation, and case law to help you stay up-to-date with current developments in tax dispute resolution. So please feel free to submit any topics you'd like us to discuss at future webinars and also feel free to submit questions throughout with the question feature that I'm sure you're all familiar with on Zoom video conferences. Today, we're aiming to wrap up at around 12:30, however, after formally ending the session, for those who would like to stay on, we will continue for up to about another 10 or 15 minutes depending how many questions we have to answer any of your questions. And if there are any that we don't get to, we will respond to you directly. And finally, please note by way of introduction that a copy of today's slides will be available online. So in turning now to topics, we have for today, the following three: number one, transfer pricing case study, successful audit defense of proposed interest rate adjustment that Pierre will discuss. Second, update on mandatory disclosure rules for reportable and notifiable transactions that Lesley will present. And third, rectification, a case study which I'll be discussing. And so with that, Pierre, please go ahead and tell us about the transfer pricing case study.
- Thank you Steven. So today I'll be presenting a case study of a recent transfer pricing audit involving one of my clients relating to the interest rate charge on an intercompany loan. In prior episode of these webinars from earlier this year, my colleague, Andre Bergeron, spoke about how the CRA had recently been zeroing in on interest rates, specifically in the context of transfer pricing audits. For those who are not familiar with transfer pricing, it is the area of tax law which deals with the price of intercompany transactions between members of a corporate group located in different countries. The transfer pricing rules provide that if two parties who are not dealing at-arms-length enter into a transaction, the terms and conditions of this transaction must be the same as those at-arms-length parties would have agreed to. In other words, if a company provides services or sells inventory or licenses IP or enters into a loan with a related party located in a different country, then these transactions must be priced for an arms-length price. In the last year, the CRA has clearly made a point to look closely at intercompany loans in the course of transfer pricing audits. And I will discuss one of these audits with you today. When a company enters into a cross-border loan with a related party, they will need to determine an appropriate arms-length rate for the loan. We must consider several factors to determine the appropriate interest rate, including the credit rating of the borrower, the duration of the loan, and some of the terms and conditions associated to the loan. We'll then look to find comparable loan agreements to determine an appropriate range of interest rates for the loan in question. This would all be documented in the company's contemporaneous documentation or what we refer to as a transfer pricing report, which would then be submitted to the CRA during an audit following a written request from the auditor. If the CRA disagrees with your analysis and believes that the interest rate should be higher or lower in order to be consistent with the arms-length standard, then the CRA will provide their own analysis along with their own set of comparables to justify their results. This brings us to our case study. In this case, a Canadian company loaned over $1 billion to a related party resident outside Canada. The interest rate charge for the years under review was 4.75%. The CRA performed their own analysis and determined that the interest rate should have been 5.25%. Now the delta between 4.75% and 5.25% is fairly small. In fact, the company's interest rate actually fell within the full range of the comparables, which formed part of the series analysis. But regardless, the CRA chose to propose an adjustment to the median of their comparables range. And despite the small delta, because the amount of the loan was in excess of $1 billion, this resulted in proposed adjustments of nearly $20 million. The CRA also indicated that they were considering assessing transfer pricing penalties equal to 10% of the proposed adjustment. And as a sidebar, if the CRA proposes transfer pricing penalties, the company must then demonstrate that they made reasonable efforts to determine and document an arms-length transfer price. So I will first provide an overview of the CRA's interest rate analysis. The first step is to determine the borrower's standalone credit rating. In other words, if the borrower was not part of a multinational enterprise and you look solely at the company's profile, what should the company's credit rating be? The CRA used a methodology published by the credit rating agency Moody's. The Moody's methodology considers various factors which are specific to the borrower's industry. Each factor is given a certain weight and once you add up the score for each factor, you obtain an aggregate numeric score. The Moody's methodology then provides a scorecard which associates a standalone credit rating to a range of scores. In this case, the scorecard indicated a Moody's credit rating of B1, which is equivalent to the Standard & Poor's rating of B+. Once you have determined the borrower's standalone credit rating, you must then determine the status of the borrower within the corporate group to see if there is any likelihood of group support in the event that the borrower is unable to repay the loan. This is a concept also referred to as implicit support. If it is determined that a parent company may come in to bail out the borrower, then you need to raise the credit rating of the borrower to reflect this possibility. The CRA use a methodology developed by Standard & Poor's to determine the borrower's credit status. This S&P methodology provides some factors to help you determine whether the borrower's group status is that of a core entity, which means that the entity is integral to the group and the rest of the group is likely to support this entity under any foreseeable circumstances. The other options are highly strategic, strategically important, moderately strategic or non-strategic. In our case, the CRA performed S&P analysis and determined that the borrower was strategically important, which is the third highest status. As a result, the standalone credit rating of the borrower must be bumped up by three notches, which brought the borrowers rating up from B+ to B++. And based on the comparable transactions that the CRA found involving borrowers with a B++ plus rating, the median of the interest rates for these comparable loans was 5.25%. For the purpose of a transfer pricing audit dispute, this presents various opportunities for the taxpayer to find weaknesses in the CRA's analysis. You see in most transfer pricing disputes, the CRA and the taxpayer each argue that their transfer price is the correct arms-length price because the comparable transactions that they identified to support their analysis are more comparable than the other side's comparables. But here, the CRA had to perform two separate analysis before doing their comparable analysis. First, there was a Moody's analysis followed by the S&P analysis. Well, in this case, we were able to find material flaws with both the CRA's Moody's analysis and S&P analysis and we prepared a submission that highlighted these flaws and this was sufficient in our case for the CRA to throw out their proposal entirely and close the audit. And this was done without needing to have a discussion about each party's comparables. And here's how we did it. We first asked the CRA to provide a copy of the Moody's methodology they used to determine the borrower's standalone credit rating. Instead of providing us with a Moody's document, we instead received a copy of the CRAs analysis which included screenshots and excerpts of a Moody's document. This immediately sounded some alarm bells. We were able to find through through the Moody's website, copies of the various methodologies published by Moody's throughout the years for the borrower's industry. It soon became apparent that the CRA used the Moody's rating methodology published on May 10th, 2017. This was very noteworthy because the loan in question was entered into in 2016, which predates the 2017 Moody's methodology. The Moody's methodology which was applicable at the time the loan was entered into was first published in 2011. You see there are a slight differences between the 2011 and 2017 methodologies. When we applied the CRA's own analysis to the 2011 methodology, this resulted in a standalone credit rating for the borrower which was one notch higher than when you used the 2017 methodology. If you then looked at the CRA's own comparables, but with the credit rating one notch higher, this was sufficient for our interest rate to be at the median of the CRA's range. Our position was that the CRA could not use a methodology that had yet to be released when the loan was entered into. And even if the CRA disagreed with this position, we had found some mathematical errors in their application of the S&P methodology that would've also been sufficient, if corrected, to increase the borrower's credit rating by one notch, which again was sufficient for our interest rate to fall within the CRA's comparables range. So what are the takeaways here? Well be very aware that the CRA is taking a hard look at intercompany loans that are subject to transfer pricing. In this case, we were talking about a difference of 0.5% for the interest rate, but that resulted in proposed adjustments of nearly $20 million. And the second takeaway is that you should not simply focus on the CRA's comparables analysis in a case like this one, which may be our reflex as transfer pricing advisors. It's important to truly drill down into the CRA's credit rating analysis to see if you can find some flaws that may be enough to overturn their entire proposed adjustment. And with that, I will pass things off to Lesley.
- Thanks, Pierre. So earlier this year we discussed the proposed new disclosure obligations for reportable transactions and a new class of notifiable transactions. The proposals also include disclosure obligations for uncertain tax positions. However, these won't be discussed today since they fall within the expertise of accountants. So the Department of Finance released the initial draft legislation for the mandatory disclosure rules on February 4th 2022, which resulted in a great deal of uncertainty amongst taxpayers and their advisors regarding their obligations under the proposed rules. In particular, due to the broad and sometimes vague definitions included in the proposals. So Finance had requested comments from the public on those proposals and following the consultation process, released revised draft legislation on August 9th, 2022. So to briefly recap, pursuant to the February legislation, a reportable transaction is proposed to be defined to mean an avoidance transaction entered into for the benefit of a taxpayer. And each transaction that is a part of a series of transactions that includes the avoidance transaction, having one and spanning the current two or the three generic hallmarks. The first is the contingent fee hallmark, which is generally a contingent fee arrangement pursuant to which an advisor of the moment, or any non-arms-length person to the advisor or promoter is entitled a fee based on the amount of the tax benefit that is contingent on obtaining the tax benefit or that depends on the number of persons participating in the avoidance transaction or series. The second is the confidential protection hallmark which exists when a promoter or advisor obtains confidential protection from the taxpayer such that the disclosure of the details of the avoidance transaction to any person or the CRA is prohibited. And the third is the contractual protection hallmark. This arises when a taxpayer or an advisor or promoter has or had contractual protection in respect of the avoidance transaction or series, including any form of insurance, indemnity, compensation or guarantee in respect of the avoidance transaction. Some other significant changes introduced in the February proposals included an exemption from reporting for contractual protection that is offered to a broad class of persons in the normal commercial transactions context, the broadening of the meaning of avoidance transaction to mean a transaction if it may reasonably be considered, that one of the main purposes of the transaction or a series of transactions of which the transaction is a part, is to obtain a tax benefit. So this means, sorry just a sec. So this means that none of the purposes of the transaction can be to obtain a tax benefit. So one of the biggest changes included the creation of a new category of notifiable transactions. Notifiable transactions will be designated by the CRA with the concurrence of the Department of Finance and will include transactions that CRA has found to be abusive and transactions that CRA has identified to be of interest and for which they require more information to determine if the transactions are in fact abusive. So the Department of Finance described six sample notifiable transactions that were released by the CRA, and these include the manipulation of Canadian-controlled corporation status to avoid anti-deferral rules that are applicable to investment income, straddle loss creation transactions using a partnership, and the manipulation of bankrupt status to reduce the forgiven amount in respect of a commercial obligation. Taxpayers, advisors, and promoters are subject to essentially the same disclosure obligations and penalties in respect of notifiable transactions that apply to reportable transactions. So if a transaction is a reportable or notifiable transaction, then every taxpayer for whom a tax benefit results or is expected to result and every advisor or promoter in respect of the transaction or of any transaction that is a part of the series of transactions that includes the or reportable transaction, who is generally entitled to a fee contingent on the tax benefit in respect of that transaction. And every non-arms-length person, in relation to those advisors and promoters is required to report the transaction. So the filing deadline for an information return has been shortened greatly. So it used to be June of the year following the year in which the transaction occurred, but now it's 45 days after the earlier of the day the taxpayer becomes contractually obligated to enter into the transaction and the day the taxpayer enters into the transaction. So penalties for failing to file an information return or reportable and notifiable transactions by the prescribed deadline, could result in significantly higher penalties. In the case of the taxpayer, the penalty is generally calculated at the rate of $500 per week that the return remains unfiled up to the greater of $25,000 and 25% of the tax benefit. If the taxpayer is a corporation and the carrying value of its assets is $50 million or more, the penalty is calculated at a rate of $2,000 per week that the return remains unfiled up to the greater of a $100,000 and 25% of the tax benefit. And in the case of a promoter or advisor, the penalty is the total of the fees charged in respect to the reportable or notifiable transaction, $10,000 and $1,000 for every day that the failure to report continues up to a maximum of a $100,000. If an information return is not filed when required and it results in a penalty that remains unpaid, the tax benefit arising from the transaction is denied and a normal reassessment period does not start until the required information return is filed and is extended by three years for all taxpayers. So a number of concerns with the February legislation were raised during the public consultation process, including the fact that there's no de minimus or materiality threshold before the reporting obligations apply. The over-broad definitions that result in reporting obligations for normal course transactions and the apparent requirement that multiple advisors within a single firm may be required to report a single transaction. Based on the input received during the consultation process, Finance released revisions to the draft legislation in August. One of the key and most welcome changes under the August proposals was the delay of the coming into force from January 1 of this year to January 1 of 2023. Even better, Finance subsequently announced on November 3rd that in order to fully assess the comments received from the public consultation, the coming into force date will be further delayed with respect to reportable and notifiable transactions to the date on which the draft legislation receives royal assent. More specific changes to the rules themselves were also introduced. So the confidential protection hallmark was amended to narrow its scope so that the confidential protection obtained by a promoter or advisor must be in respect of a tax treatment in relation to the avoidance transaction, rather than just in respect of the avoidance transaction. The technical notes to the amendment further clarifies that the amendment provides that the protection of trade secrets that do not relate to tax, don't give rise to a reporting obligation. In addition, the exclusion from reporting requirements for contractual protection that is offered in the context of normal commercial transactions was clarified to remove the requirement that the contractual protection be offered to a broad class of persons and to provide that the exclusion applies if the contractual protection applies in a normal commercial or investment context in which parties deal with each other at arms-length and act prudently, knowledgeably and willingly and does not extend to the tax treatment in respect of an avoidance transaction. A new definition for tax treatment is also added. A tax treatment of a person means a treatment in respect of a transaction or series of transactions that the person uses or plans to use in a tax return or information return and includes the person's decision not to include a particular amount in a tax or information return. The definition of tax treatment is also relevant to the amendment to the reporting obligation for reporting for reportable transactions. That provision is amended to require an information return to be filed by every person for whom a tax benefit results, or for whom tax benefit is expected to result based on the person's tax treatment of the reportable transaction. Finance has indicated that this amendment is intended to ensure that reporting is required in circumstances where a person's filing position is successfully challenged. The February proposal is required reporting by multiple parties, including the taxpayer and each promoter and advisor who provides any assistance or advice regarding the creating or implementing of the transaction or series. This could require multiple advisors within a single accounting or law firm to file an information return in respect of a single transaction. This is particularly concerning as even a person who simply implements a transaction such as the corporate associate who is not involved in the tax planning may be required to file an information return. The August proposals marginally reduced the compliance burden by providing that reporting is not required by a person solely because they provided clerical or secretarial services with respect to the planning. At the same time, the carve out for clerical staff suggests that Finance does indeed want every employee, partner and shareholder of a firm who worked on a transaction to report in respect of a single reportable transaction. There is some relief for notifiable transactions. Reporting obligations that would otherwise apply to employees and employer or partners of a partnership, don't apply if an information return is filed by the employer or the partnership in respect of the notifiable transaction and that filing is deemed to have been made by each employee of the employer or each partner of the partnership to whom the reporting obligation applies. Finally, the normal reassessment period does not start until the required information return is filed and is extended by three years for individuals and Canadian-controlled private corporations, but by four years for all other taxpayers. Under the February draft, the extension was three years for all taxpayers. So to conclude, the August draft legislation for reportable and notifiable transactions provides some clarification to you and narrowing of the February version. However, uncertainty remains such as the issue of whether every employee or partner of an advisory firm is required to file a separate information return for a reportable transaction. Therefore, the delay of coming into force of the new rules until the draft legislation receives royal assent is very welcome. Based on the comments on this regarding Finance, there may be further refinements made to the draft legislation which will hopefully address some of these uncertainties. So thanks for your time. My colleague, Steven Novoselac, will now go through a case study on rectification.
- Thanks, Lesley. So again, our third topic today is indeed a case study in rectification in a tax context. The two applicants who are Sleep Country Canada Holdings Inc. and Sleep Country Canada Inc. As an equitable remedy, applications seeking rectification are made in provincial superior courts which have jurisdiction to grant equitable relief or what's called inherent jurisdiction. As is typical for applications seeking rectification, the respondent was the Attorney General of Canada representing the CRA, who was the only party who could be adversely impacted by the relief sought. And the attorney General did not oppose the application. The court granted the rectification which avoided an unintended adverse tax result in the context of a share exchange transaction. So for this topic, I'll first discuss the background facts. Then second, how the court applied the test for rectification to reach its conclusions. And third and finally, some practical considerations. So in terms of background facts, as you I'm sure will be aware, the applicants are significant players in the retail mattress business. They entered into a share exchange transaction with one another, which was one component of a reorganization that was implemented to facilitate an initial public offering of certain equity interests in their business on a tax-efficient basis. In the share exchange agreement, however, the number of certain shares to be issued was incorrectly recorded as about 12 1/2 million shares, whereas the correct number was just over 124 million shares. This had the effect of omitting the intended consideration of the difference between these two amounts or about 111 1/2 million shares. This error was then simply transposed into other transaction implementation documents as well as the corporate documents recording the transactions. Subsequent tax filings, however, did record the correct number of shares and the applicants relied on that as further evidence of their true intentions and their agreement throughout. So turning now to the test the court applied to decide whether to rectify the documents, the court applied the four requirements tests from the Supreme Court of Canada's 2016 decision in the well known Fairmont case, which is a leading case on rectification. Number one, the parties had reached in a prior agreement. Number two, the agreement was still effective when the instrument was executed. Number three, the instrument failed to record accurately that agreement. Four, if rectified as proposed, the instrument would carry out that agreement. And the court did find that all four requirements were met. The court referenced and did much of its analysis on the Fairmont decision, summarizing that rectification allows the court to achieve correspondence between the party's agreement and the substance of the legal instrument intended to record that agreement where there is a discrepancy between the two. And it went on to explain that the applicants bear the onus of establishing that this should be granted. And so the in terms of conclusions, the court held that the evidence was overwhelming that the parties had to reach an agreement with definite, ascertainable terms and a clear intention which was consistent with the subsequent conduct including the tax filings. Similarly, there was no doubt that the documents sought to be rectified did not accurately record the agreement between the parties and that rectification would result in the documents carrying out the agreement that was reached. The court agreed with the applicant's submission that rectification can be available if the four requirements are met, even if it would have the effect of allowing a party to avoid adverse tax consequences. So now for a few practical considerations, the case illustrates how the Supreme Court's decision in Fairmont, as well as similar cases, have significantly reduced the scope for rectification in a tax context. Previously, and for many years, the leading case on rectification, at least in Ontario, was the Ontario Court of Appeals decision in 2000, in the well known case called Juliar. The tests from Juliar applied much more broadly. Essentially, it boiled down to two elements, intention and mistake. In the tax context, intention could include an intention to achieve favorable tax consequences. And mistake was interpreted broadly to include the manner in which transactions were structured. Therefore, before the Fairmont decision, rectification could avoid an unintended tax consequence in a much broader range of circumstances. Once an attention for tax efficiency and a mistake were satisfactorily established, the court was willing to do much more than merely rectify an instrument that recorded an agreement. The relief the court granted could include significantly restructuring the transactions such as replacing a merger by windup with an amalgamation. After Fairmont, rectification has been applied certainly much more strictly and much more like traditional illustration, which is, you know, where two parties agree to the purchase and sale of a cow, but the written instrument to affect the transaction mistakenly says it's a horse and the court rectifies the instrument to say cow instead of horse. Today's case is something like that with simply the wrong number having been mistakenly transposed throughout the documents. So is there a future for a more broadly-based rectification doctrine in a tax context? This could be accomplished through amendments to provincial legislation and we're aware of at least one instance where submissions have been made to the Alberta Minister of Justice and Solicitor General regarding amendments that would have that effect. Though only time will tell whether any legislative amendments like this will ever be implemented, but for now taxpayers need to live with the current more restrictive rectification regime. And so I hope that's been a helpful discussion on rectification and we would be grateful if you could take a moment to scan the QR code to take our short survey. And as mentioned at the outset, please do look for our invitation to the next webinar in the new year. Thank you very much again for joining today. Have a great afternoon and all the best for a safe and happy holiday season. And also as mentioned at the outset, while today's formal session is now concluded, we are going to continue with those who would like to stay on for a few moments to answer any questions. I should mention that Pierre Alary had to take his leave already from today's webinar after presenting his topic and so won't be able to attend to answer any questions today. So apologies for that. But he had an urgent client matter to address. And so now, let's see what questions we have. So, all right. We have one dealing with Lesley, your topic, "Do the new reportable transaction rules apply to lawyers affecting a reorganization or a capital gains thread?"
- So thanks for the question and the answer is possibly yes. And that's because of the very broad definition of advisor that's used for reportable and notifiable transactions. And that means any person who has provided any assistance or advice with respect to creating, developing, planning, organizing, or implementing the transaction or series. So even a corporate lawyer who hasn't been involved in the tax plan could be required to report if, you know, any of the hallmarks were present. In particular for advisors, if they received a contingency for the work. Like an example would be if you charged a rate per Section 85 agreement that you would have drafted for this particular file, then the fee hallmark would've been met. And there is a carve out from the reporting obligations for information that is protected by solicitor-client privilege. And in the prior iteration, they used the statutory definition of solicitor-client privilege, which was quite a bit narrower than the common law definition. So that statutory definition has now been removed, which is great, but the problem is that the solicitor-client privilege exception only applies to lawyers. So while a lawyer might not be required to report because of that privilege, the taxpayer or promoter would not be subject to the same exclusion. So, you know, we question how useful that exclusion actually is.
- All right, thanks, Lesley. There's a follow up question or another question on these rules as well. "What kind of information will have to be disclosed under the new rules?" Oh, you're just on mute there, Lesley.
- Too many screens. Sorry.
- It's all right.
- So there is a current prescribed form for reportable transactions. It's the RC312. And that one requires a lot of detail including like a description of the reportable transaction itself, like including the steps taken and a description of the tax benefit. And you also have to disclose the role of each party involved and how the relevant provisions of the tax act apply to allow the taxpayer to get that benefit. And a prescribed form hasn't been released yet for notifiable transactions, but Finance provided a summary in the February backgrounder to the draft announcing the changes. And so the information would be similar and it requires a description of the transaction in sufficient detail for the CRA to understand the structure and the expected tax treatment and potential benefits expected to result from the transaction. And the Finance has indicated that it would also require the person filing the form to identify every other person that's required to file an information return for the same transaction.
- All right, thank you. So a couple questions on rectification. "Given the more stringent test, have rectification applications become less frequent?" Yes, that's a short answer. Certainly, we've seen a marked decline in the number of applications seeking rectification over the last several years in view of that decision. Someone asked for the citation for that leading Supreme Court Canada decision that I mentioned called Fairmont, and the citation is 2016 SCC 56. 2016 SCC 56. It's another question on rectification. "If the only other party to the application is the Attorney General representing the CRA and the Attorney General does not oppose the application, why does the court go through all of the rectification analysis?" And so it's important to understand how the process unfolds, typically, with applications seeking rectification, normally what you do as counsel is you compile all of the materials, including the notice of application, the affidavits in support of the application, and a factum, which is the written submissions, a written argument, and you serve all of that on the Department of Justice Council. They will then canvas that with a committee that's unsurprisingly known as a rectification committee and normally, I come to you, you as the taxpayers counsel, with the number of questions and that can be then hopefully addressed. And ultimately, your goal as counsel for the taxpayers is to obtain from the CRA and/or from counsel for the CRA, a letter of non-opposition. They will normally never consent per se to the application, but they will issue a letter in an appropriate case, which confirms that they are not opposing the application. And the courts will certainly look for that. They'll want to know what the CRA's position is on a rectification application in a tax context where the outcome of the rectification, if granted, would eliminate an unintended adverse tax consequence. However, the court must still exercise its discretion in deciding whether or not the test for rectification is met. And so that's why the court will always settle the analysis as was done in the case that was discussed today. All right, so the only other question or questions we have pertain to Pierre's topic and as mentioned, he needed to take his leave, so we will respond to that question directly. And so otherwise, thank you very much again for your participation and have a great, happy holiday season and we'll look forward to seeing everyone again in the new year. Have a great afternoon. Bye-bye.