TCC: Transfer-Pricing Structure Unsupportable

Marzen Artistic Aluminum Ltd. (2014 TCC 194) reminds Canadian taxpayers that contractual arrangements between entities may be subject to transfer-pricing adjustments if one of the entities lacks substance and provides minimal value. Penalties may also be imposed when a taxpayer has not made reasonable efforts to determine arm’s-length transfer prices.

At issue were the non-arm’s-length marketing service fees paid by the taxpayer (Marzen) to its wholly owned Barbados subsidiary (SII) in the 2000 and 2001 taxation years. Marzen and SII entered into a marketing and sales service agreement (MSSA) under which Marzen agreed to pay SII a monthly fee equal to $100,000 or 25 percent of gross sales initiated by SII, whichever was greater. In computing its income for 2000 and 2001, Marzen deducted $4.2 million and $7.8 million, respectively, for fees paid to SII under the MSSA. In the same years, SII, which paid nominal tax in Barbados, paid dividends to Marzen in the amount of $2.0 million and $5.3 million, respectively. Marzen received these dividends tax-free because they were paid out of SII’s exempt surplus.

The first issue before the court was whether the price paid under the MSSA was equal to the price that would be paid between two arm’s-length parties. Sheridan J determined that the sole value of SII appeared to be represented by the role played by its director. Aside from a possibly “game-changing” idea to focus sales on a specific market in California, the evidence indicated that the director did not provide substantive services. Therefore, Sheridan J concluded that an arm’s-length party would not have paid the inflated fees that Marzen paid for the basic services that SII provided. Other than the attractive tax advantages that resulted from the MSSA, SII was an empty shell that functioned merely as a flowthrough entity.

The taxpayer’s expert witness argued that even if the marketing fees could not be justified on the basis of SII’s services alone, they could be justified as a joint payment for the services of SII and the taxpayer’s US subsidiary as an “amalgam.” The court disagreed, saying that this was contrary to the 1995 OECD transfer-pricing guidelines, which require an entity-by-entity assessment. Instead, the comparable uncontrolled price method was used to determine that a reasonable arm’s-length party would have paid SII no more than the price paid for the management and administrative services provided by the director. As a result, only a small portion of the fees was deductible.

The second issue before the court was whether Marzen was subject to a penalty under subsection 247(3) of the Act because the $5 million threshold for imposing the penalty was met in the 2001 taxation year. At trial, the taxpayer revealed that it had determined the percentages and formulas in the MSSA without consulting professional advisers or comparable businesses. Sheridan J concluded that the documentation provided to the CRA in respect of the transfer-pricing arrangements did not factually meet the reasonableness standard in the Act; therefore, the taxpayer was subject to a penalty to the extent that the threshold was met. The court’s conclusion supports the CRA’s administrative position as recently published in Transfer Pricing Memorandum TPM-05R (“Requests for Contemporaneous Documentation”), which states that penalties are warranted when taxpayers provide inadequate or insufficient contemporaneous documentation in a transfer-pricing audit.

The transfer-pricing structure in Marzen can be contrasted with that in Alberta Printed Circuits Ltd. (2011 TCC 232). In that case, the court denied the CRA’s reassessment of setup fees paid by the taxpayer to its related Barbados company (APCI). The evidence indicated that APCI provided specialized setup and information technology services, and its director was actively involved in developing technical software and training local workers. If the evidence had proved to the court’s satisfaction that SII or its director had provided some value (such as marketing analysis, consumer research, or other services) or assumed some business risk in return for the marketing fees, the taxpayer would have had a more supportable transfer-pricing structure.

Shaira Nanji
Dentons Canada LLP, Toronto

Canadian Tax Focus
Volume 4, Number 3, August 2014
©2014, Canadian Tax Foundation