The Tax Court of Canada decided in favor of the taxpayer in AgraCity Ltd. v. The Queen (2020 TCC 91), marking one of only a handful of transfer pricing judgments in the modern history of Canadian transfer pricing, i.e., since Section 247 of the Income Tax Act (ITA) received Royal Assent in 1998. The Crown did not appeal the decision.
Transfer pricing cases tend to be some of the most complex in the realm of tax law. Chapter 1 of the Organization for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (July 2017) (OECD Guidelines) provides, at Paragraph 1.6, that “[where] conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.” The paragraph describes the “arm’s-length principle” which is the valuation standard that underlies global transfer pricing. Its application involves intensive fact finding, industry and value-chain research, and financial/economic analyses. A typical transfer pricing report documenting such an analysis for a material cross-border intra-group transaction can easily breach 100 pages, and multinationals might produce dozens of such reports each year depending on the complexity of their supply chain and intra-group flows.
Certain jurisdictions (such as the U.K.) have adopted the OECD Guidelines directly into their law. Others (most notably, the U.S.) have produced lengthy and detailed regulations to provide taxpayers with at least some clarity with respect to how to perform transfer pricing analysis. Canada has taken the approach of neither, leaving taxpayers and the Canada Revenue Agency (CRA) to interpret Section 247 based upon the clues provided by limited jurisprudence. For this reason, whenever a transfer pricing decision is rendered, the entire Canadian transfer pricing community pays attention.
AgraCity marks the most recent example of the Crown’s attempt to apply sham, recharacterization, and repricing provisions in the context of transfer pricing. The AgraCity decision provides important insights for anyone practicing transfer pricing in Canada.
Prior to this ruling, Ted Gallivan, assistant commissioner of CRA’s International, Large business and Investigations branch, had already intimated that unless CRA gets a better result in the Supreme Court in cases such as Cameco (for which the period for applying for leave to the Supreme Court expired on Nov. 12, 2020) and other decisions (presumably Alta Energy), then amendments to the Income Tax Act’s transfer pricing rules would be sought. According to a post in the legal blog Tax Interpretations, the comments were heard by Gallivan of Parliamentarians. The result in AgraCity likely reinforces the Parliamentarians’ sentiment further.
The taxpayer, AgraCity Ltd. (AgraCity), was part of the Farmers of North America group of companies (FNA Group), a member-based organization established to support Canadian and U.S. farmers. During the years in question, AgraCity had a services agreement with NewAgCo, Inc., a Barbados-based affiliate (NewAgCo Barbados) in connection with NewAgCo Barbados’ sale of a glyphosate-based herbicide (ClearOut) to Canadian farmer-members of FNA Group.
The sale, distribution, and use of herbicides in Canada is regulated by the Pest Management Regulatory Agency (PMRA). Although at that time ClearOut was an unregistered product, FNA Group identified an opportunity to supply the herbicide to Canadian farmers by becoming a sponsor under the Own User Import (OUI) program, a program which made the product eligible for farmers to purchase outside of Canada, from any source whether or not affiliated with FNA Group, and to import it into Canada for themselves for their own use.
In 2005, following the acceptance of ClearOut into the OUI program, FNA Group put in place a business operations structure in which FNA Group would be able to promote the availability of ClearOut to its farmer-members and facilitate the purchase and importation of ClearOut. It remained forbidden by the PMRA for anyone to offer ClearOut for sale in Canada, or to sell it in Canada, but “promotion” was allowed, as was importation. To this end, NewAgCo Inc. (NewAgCo U.S.) was established by the owners of FNA Group to be used to purchase ClearOut in the U.S. from independent suppliers, to warehouse it in its rented warehouse facilities, and to sell it to the FNA Group’s farmer-members.
The demand for ClearOut by FNA Group farmers in Canada turned out to be so significant that it greatly reduced the available supply of ClearOut in the U.S. NewAgCo U.S. sought to acquire all the ClearOut it could from any available sources, including Chemical Products Technology (“CPT”) (which was the largest U.S. supplier of eligible ClearOut available for the Canadian market under the OUI program).
NewAgCo U.S. used AgraCity to attend to the logistical and related activities of sales and deliveries to the Canadian buyers and AgraCity was paid an amount per liter of ClearOut sold to perform these services. Another entity in the FNA Group promoted the availability of ClearOut. That entity’s personnel were responsible for all of the farmer-member service activities up to placing the order and fixing its terms for payment delivery and importation. The FNA Group entity also worked with each farmer-member to facilitate and administrate the OUI process, as well as to organize and direct delivery to the farms. AgraCity was thereafter responsible for all of the logistics required to complete NewAgCo U.S.’s sales, including relating to importing and delivering to the farmer-member purchaser. This structure operated throughout 2005.
After the end of the 2005 agricultural season and before the 2006 season began, the FNA Group owners decided to transfer NewAgCo U.S.’s Canadian ClearOut sales business to a new corporation to be incorporated in Barbados. This was done primarily to minimize the U.S. tax payable on the sales profits recognized by NewAgCo U.S. Further, in December 2005, CPT (NewAgCo U.S.’s largest supplier) sold its ClearOut rights and inventory to Albaugh North America (Albaugh), another independent chemical supplier. In negotiations between Albaugh and one of the two brothers who owned FNA Group, the group secured an exclusive supply agreement with Albaugh.
NewAgCo Barbados was incorporated in March 2006 and shortly thereafter took on the role NewAgCo U.S. had until then carried on. NewAgCo U.S.’s orders from the FNA Group farmer-members in the fall of 2005 for spring 2006, and its ClearOut inventory and rights, were transferred to NewAgCo Barbados. NewAgCo Barbados also purchased related business assets from NewAgCo U.S. and took over its U.S. warehouse space. The brother who had negotiated the arrangement with Albaugh was also given express (though unwritten) authority by his older brother, the Director of the newly-incorporated NewAgCo Barbados (and also the CEO of FNA Group), to set NewAgCo Barbados pricing and interface with Albaugh on behalf of NewAgCo Barbados.
On March 29, 2006, AgraCity entered into a service agreement with NewAgCo Barbados for support services, including “promotion, invoicing, collection of receivables, payment of supplier invoices, bookkeeping services, logistics, border services, reporting and any other services agreed to from time to time,” similar to the prior arrangement with NewAgCo U.S. As NewAgCo Barbados had no employees at any time during the period, it relied upon the actions of its Director, the Director’s younger brother (who continued to interface with Albaugh and set the sales price to Canadian farmer-members), as well as AgraCity (pursuant to the services agreement) for all of its operational activities. The service fee to AgraCity was specified in cents per litre and resulted in approximately $2 million of fees paid to AgraCity during the period. In comparison, NewAgCo Barbados reported net sales profits of approximately $6 million during 2007 and 2008.
AgraCity was reassessed for its 2007 and 2008 taxation years (ended March 31st) for an amount equal to 100% of NewAgCo Barbados’ profits during those years. The CRA did not reassess the 2005 or 2006 years (i.e. the years in which AgraCity was providing services to NewAgo U.S.).
The Crown’s primary position was that the services agreement between AgraCity and NewAgCo Barbados represented a sham based on the assumption that NewAgCo Barbados did not perform any functions in the context of the transactions (and so provided no value to which profits should be attributed). The Crown’s alternative position was that the provisions as stated in paragraphs 247(2)(b) and (d) of the ITA permit the recharacterization of the transactions because arm’s-length parties, unlike AgraCity, would not have allowed NewAgCo Barbados to be part of the transactions or to make any of the profits. The final argument advanced by the Crown was that the provisions as stated in paragraphs 247(2)(a) and (c) of the ITA applied and the services agreement should be repriced.
Summary of the Ruling
The court heard from eleven material/fact witnesses, (1) the founder of FNA Group (also the CEO of FNA Group and director of NewAgCo Barbados); (2) the president of AgraCity; (3) the Controller of the FNA Group; (4) the President of the U.S. supplier of ClearOut; (5) a member service representative of FNA Group and the national member service manager; (6) an FNA Group farmer-member; (7) a contract worker at FNA Group and AgraCity; (8) a member service representative of FNA Group; (9) the executive director of the PMRA at Health Canada; (10) the director general of Compliance and Laboratory Services at the PMRA; and (11) the president of the Canadian Federation of Agriculture, who was a member of the PMRA’s OUI Task Force in the years in question.
In addition, the court heard from the following four expert witnesses, (1) an Attorney-at-Law in Barbados, an expert in Barbados corporate law; (2) the Joint Global Head of Transfer Pricing for Grant Thornton International, also the Leader of Grant Thornton’s transfer pricing practice in Canada; (3) a transfer pricing specialist and Partner of Deloitte & Touche LLP; and (4) an expert in the economic analysis of transfer pricing, who was a member of the CRA’s Transfer Pricing Review Committee in the years in question.
The court dismissed the CRA’s primary position, ruling the evidence fell “far short” in establishing enough evidence to show the Barbados arrangement was a sham (par. 107). Specifically, the CRA failed to show that AgraCity Canada and NewAgCo Barbados represented to anyone their legal rights and obligations were different than what they knew or understood them to be, or they sought to deceive anyone about their purpose or intention or reasons for entering into any of the transactions.
In reaching this conclusion, the court found that,
- In 2005 NewAgCo U.S. was chosen to be the purchaser and seller of the ClearOut because it was generally understood by James Mann (the CEO of FNA Group) and by others involved in the FNA Group that a non-Canadian entity was required under the OUI program as administered by the PMRA, and that FNA Group could only promote ClearOut’s availability under that program to its members and potential members. Further, he found their understanding was a reasonable one in the circumstances. This understanding was unchanged when NewAgCo U.S.’s business was transferred to NewAgCo Barbados in early 2006.
- NewAgCo Barbados was the purchaser of the ClearOut, and was the beneficial owner of the ClearOut acting on its own account upon purchasing it until it sold the ClearOut to the Canadian farmers. It was not a holder of a buy-sell contract agent, bare trustee, prête-nom, or any form of nominee or nominal title-holder.
- NewAgCo Barbados paid for its purchases and received the sales proceeds for its own account.
- NewAgCo Barbados had sourced all of the relevant U.S. ClearOut that it had bought and sold. Jason Mann (the CEO’s younger brother) did this on behalf of NewAgCo Barbados, which had duly authorized him to do exactly that. NewAgCo Barbados was buying all of the U.S. ClearOut that it could locate.
- NewAgCo Barbados had Jason Mann negotiate an exclusive supply agreement with Albaugh which secured NewAgCo Barbados access to 95% of U.S. ClearOut manufactured by the only person with the right to manufacture U.S. ClearOut: Albaugh.
- NewAgCo Barbados took real foreign exchange risk in its ClearOut sales activities because it was buying and incurring related expenses in U.S. dollars and selling in Canadian dollars. That foreign exchange risk was able to be minimized with respect to the costs of purchasing the U.S. ClearOut, but not with respect to some of the U.S. transport costs for delivering the ClearOut once sold to the Canadian farmers, or U.S. warehouse costs and other expenses associated with those activities that were performed in the U.S.
- NewAgCo Barbados took real risk as owner of large volumes of a chemical based regulated herbicide applied to food products, and as an international transporter of that product to the Canadian farmers.
- The services agreement between AgraCity and NewAgCo Barbados was the proper transaction whose terms, rights, and obligations were to be reviewed for purposes of the transfer pricing rules.
Similarly, the court dismissed the CRA’s secondary Section 247 2(b)/(d) recharacterization position due to lack of evidence. Regarding CRA’s tertiary position, Section 247(2)(a)/(c), the court concluded that AgraCity’s service fee was arm’s-length in the years in question based on the only evidence the court had on the point, which was presented by one of AgraCity’s experts, Mr. Brad Rolph, the National Leader of Grant Thornton’s Transfer Pricing practice in Canada. Mr. Rolph provided evidence that AgraCity’s returns were at the higher end of the range of comparable cost plus returns from the available data he could obtain, and that AgraCity’s service fee represented a reasonable rate of return for its primarily logistics services.
The ruling presents important takeaways relating to the following areas:
- Sham and Window Dressing in Transfer Pricing Cases
- Recharacterization Pursuant to 247(2)(b)/(d)
- Repricing pursuant to 247(2)(a)/(c)
- Functional Analysis
- Asset and Risk Analysis Legal Form and Contracts;
- Transactional Net Margin Method (TNMM) and Benchmarking; and
- Burden of Proof
Key takeaway #1 – SHAM / Window Dressing in Transfer Pricing Cases
The Crown’s primary position was that the transactions were a sham, or window dressing. As fallback positions, the Crown argued 247(2)(b) (recharacterization) and as a third argument 247(2)(a) (repricing). This is a similar strategy as had been recently pursued in Cameco Corporation v .The Queen (2014 TCC 45) (Cameco).
The concept of a “sham” in the context of Canadian tax cases is relatively well established, as shown in the decades of jurisprudence cited in Cameco (pars. 582 to 586). As the court said in AgraCity, “the issue of whether [there] was a sham requires the court to consider whether AgraCity entered into agreements and transactions that were intended to deceive and mislead others, primarily the [Crown], into believing that the rights and obligations between [AgraCity] and related parties were different than what they truly were. The deceit can be evident from looking at both how the transactions were constructed and how they were conducted” (par. 17).
The court concluded that the Crown’s evidence did not establish that either that the parties to the transactions sought to present to anyone that the legal rights and obligations of the parties were different than what they knew or understood them to be, or that any of those parties sought to deceive anyone about their purpose or intention or reasons for entering into any of the transactions (par. 77).
The court identified 14 “key reasons” for its conclusion. The highlights from the 14 reasons were:
- The structure involving NewAgCo Barbados was essentially the same as a prior structure involving a U.S. entity (in the place of NewAgCo Barbados), which was done for bona fide non-tax purposes with no reason to, or intention to, deceive anyone. The identical naming of the U.S. and Barbados companies also “hardly concerned” the court, as there was no evidence of a deceit that would purport the companies to be Canadian (pars. 77 (i) and (ii).
- There existed a commercial rationale for the use of a non-Canadian company to make the sales; it was clear based on the evidence that NewAgCo Barbados did in fact make the sales; and it was clear based on the evidence that counterparties knew they were transacting with NewAgCo Barbados as a purchaser and reseller of product (pars. 77(iii) to (v)).
- NewAgCo Barbados also did actually bear material risk (foreign exchange, warehouse, inventory, commercial transport, product liability) and it owned a “very valuable” asset: the exclusive supply agreement with Albaugh, factors both aligned with its purported purpose (i.e., as an intermediate distributor) (pars. 77(vi) and (vii));
- NewAgCo Barbados undertook all appropriate steps in accordance with Barbados corporate and commercial law, and there was also no serious suggestions that any of the agreements, transactions, or activities did not comply with U.S. or Canadian law (pars. (viii) and (xi));
- Less than perfect paperwork with respect to addressing, invoicing, and legal agreements also did not indicate an intent to disguise the facts and deceive third parties (pars. 77(x) to (xii)); and
- Finally, the court found that neither a year-end transfer pricing adjustment procedure nor “confusing, incomplete or inadequate” books and records were, on their own, evidence of deceit (pars. (xiii) and (xiv)).
Of particular note to taxpayers and practitioners, the court clearly describes that an analysis in the context of ‘sham’ or ‘window dressing’ law must focus on evidence of deceit in the structuring of transactions and the actual conduct associated with them. Critically, the analysis seemed not concerned with the Crown expert’s arguments invoking concepts of functional substance, value, and economic alternatives, only whether the taxpayer structured their arrangements transparently and whether they then conducted themselves in accordance with that transparent structure.
Key takeaway #2 – Recharacterization Pursuant to 247(2)(b)/(d)
The recharacterization provisions of 247(2)(b)/(d) are anti-avoidance provisions intended to allow the CRA to compute transfer pricing adjustments by notionally replacing the actual transaction or series with an alternative transaction or series, then pricing that alternative. The provisions were previously addressed in three transfer pricing cases: Cameco, Marzen Artistic Aluminium Ltd. v. The Queen (2014 TCC 45) (“Marzen”), and General Electric Canada Company v. The Queen (2009 TCC 563) (“General Electric”), but the Crown has never prevailed in court on the basis of a recharacterization reassessment.
The court cited Justice Webb from Cameco in its explanation of paragraphs 247(2)(b)/(d) of the Act: they “apply only where a taxpayer and non-arm’s length non-resident have entered into a transaction or a series of transactions that would not have been entered into between any two (or more) persons dealing at arm’s length, under any terms or conditions. In such a situation, the transaction or series of transactions that would have been entered into between arm’s length persons is substituted for the transaction or series of transactions in question, with the appropriate terms and conditions” (par. 21, from par. 82 of Cameco).
In essence, the legislation is intended to tackle cases in which a taxpayer has purposefully structured a transaction to be commercially irrational so as to preclude the identification of arm’s-length comparables and so preclude an otherwise conventional transfer pricing exercise based on benchmarking.
The court dismissed the applicability 247(2)(b)/(d) in AgraCity because of an absence of evidence. Since the reassessments were made in reference to 247(2)(a)/(c), not the recharacterization provisions, and the Crown’s expert focused on that provision, the court was not provided evidence directly addressing the question of 247(2)(b)/(d), i.e., whether any persons dealing at arm’s-length, under any terms or conditions, would have entered into the transaction or series.
The court further suggested that the Crown’s position on 247(2)(b)/(d) could even further be dismissed using the Crown’s own expert witness’ words. The Crown’s position, according to the court, was effectively “that it is obvious that arm’s-length commercial parties would never agree to let NewAgCo Barbados have any of the profits if it served no function in the transactions given that it had no assets, employees, resources, or other role or value to contribute to the profit making enterprise or to bring thereto” (par. 82). However, the Crown’s expert witness indicated that NewAgCo Barbados was “an entity that adds value by its existence only” as “the holder of the buy-sell contract” (par. 85). Further, the Crown’s expert witness also agreed in his report that the service agreement was the transaction under review (not some notional other transaction) and that the contract, subject to proper pricing, was one to which arm’s-length parties would agree (par. 84).
The court essentially reiterated the message in Cameco that paragraphs 247(2)(b)/(d) are concerned about whether the tested transaction is generally commercially rational, not whether arm’s-length parties would have entered into the transaction had they been in otherwise identical circumstances as the actual parties. AgraCity therefore marks another example of how difficult it may be for the Crown to uphold a reassessment pursuant to 247(2)(b)/(d). Based on the framework outlined in Cameco, Marzen, General Electric, and now AgraCity, it becomes a challenging thought exercise to imagine a transaction to which no hypothetical arm’s-length persons would agree given any terms and conditions. The result puts further pressure on the use of 247(2)(b)/(d) as a broad recharacterization measure, let alone given the further requirement which states that for 247(2)(b)/(d) to apply the transaction must also be reasonably considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit.
Part 2 of the article will discuss the court’s take on repricing under Section 247(2)(b)/(d); functional analysis, asset and risk analysis, legal forms and contracts, the transactional net margin method and benchmarking; and the burden of proof.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Peter Kurjanowicz is a transfer pricing partner at Grant Thornton LLP in Canada and leads the firm’s complex financial instrument pricing sub-specialty group. Mi Li is a senior analyst on the transfer pricing team.