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Published: September 21, 2017
Updated: September 21, 2017
The transfer pricing environment continues to change, and provide opportunities for taxpayers to assess their transfer pricing policies and evaluate audit defense strategies. Transfer pricing is also increasingly important in resolving other business disputes. In a recent case not involving the tax authorities or a dispute over taxes, the use of a transfer pricing methodology, and interpretation of intercompany agreements, was the key to the final resolution. This summary of the most recent case law, with interesting settlements, highlights the impact transfer pricing is having both on taxes paid by international businesses and on resolutions for non-tax disputes
Cameco – contrasting approaches by the CRA and IRS
Cameco is one of the world's largest uranium producers, with mines in Canada and the U.S. In 1999, the company restructured and established a Swiss Company (Swiss Co) to purchase uranium from the Canadian mine and other third parties. At the time, the uranium was being sold back to the U.S. for resale. Presumably at a later date, the U.S.-produced uranium was also sold to the Swiss Co.
Both the Canada Revenue Agency (CRA) and the Internal Revenue Service (IRS) have been actively auditing the purchase of uranium by the Swiss Co, with contrasting results.
In Canada, the Crown is seeking $2.2 billion of tax, for the 2003-2015 tax years. In the Tax Court, the Crown has three clear alternative arguments. The Crown's first argument uses the sham doctrine, on the basis that there was no real business undertaken by the Swiss Co. The second argument uses the transfer pricing recharacterization provisions, on the basis that there was no bona fide non-tax reason for the Swiss Co's inclusion in the transaction. Lastly, the Crown is relying on adjusting the price for which the product was sold to the Swiss Co.
From a technical perspective, this is the first transfer pricing case to include three clear alternative arguments, and it is hoped that this case will help clarify further which argument is to be used depending on the circumstances.
To date, Cameco has paid the CRA $264 million in cash and provided $421 million in letters of credit. The company expects to spend $57 million to defend this case. Final arguments were heard in September 2017, with the decision expected to be issued six to 18 months later. If the decision is appealed, further costs will be incurred.
Note, the CRA had requested that an additional 25 employees be made available for oral interviews (outside of the Tax Court process), to verify information included in the transfer pricing reports. The Tax Court rejected the CRA's demand for these oral interviews since Cameco had met all other audit requests with written responses. There was also a concern that oral interviews would violate Tax Court rules and could jeopardize the resolution of tax cases.
In the U.S., the IRS had proposed an adjustment of US$122 million, for the 2009-2012 tax years. This adjustment was for the sale of uranium to the Swiss Co (the same transactions that the CRA examined) and to increase the compensation to a U.S. sales entity. In addition, penalties of US$8 million were also proposed.
In July, Cameco received confirmation of the settlement agreement, which includes a cash payment of US$122,000, with no penalties being applied.
While the two tax authorities have a common transaction, albeit with significantly different proposed adjustments, the IRS has settled for significantly less than the proposed adjustment, and waived the penalty. While we do not have the full facts in each case, this is a timely reminder that each tax authority will evaluate similar transactions independently, and settlement can be an extremely efficient method of resolving transfer pricing audits. We await with interest the Canadian Tax Court's judgment on the use of the Crown's three alternative arguments, and the value of the adjustment.
Eaton1 memorandum opinion - reassurance on the IRS' ability to cancel APAs
A recent U.S. Tax Court memorandum reviewed an important question: If the IRS no longer agrees with the position taken in an Advance Pricing Agreement (APA), can its administrative privileges be used to cancel the APA?
Ordinarily, an APA provides the taxpayer with certainty in the transfer pricing treatment of the specified cross-border transaction for a set period of time. An APA is attractive in certain circumstances, as it provides shelter from rigorous audit activity and reduces compliance costs. However, the taxpayer does have to provide extensive business information, which can then be used to provide the basis of the material assumptions. The material assumptions are key to the APA, and can include parameters in respect of the type of business, related and third party transactions, industry or general economic conditions. When a material assumption has been breached, the APA can then be cancelled by the tax authority.
Eaton, a large multinational company, had entered into two APAs with the IRS: for the 2001-2005 tax years and the 2006-2010 tax years. At the time of negotiating each APA, a profit split method was accepted. The IRS had discussed using a different profit split method; however, this was not included in the APAs. Later, the IRS cancelled the APAs based on the preference for a different profit split method, and increased the company's taxable income by US$368 million.
In Eaton's case, the company argued that it had not omitted or misrepresented material facts during the negotiation process, and the material assumptions were not breached. However, the IRS used its administrative privileges to cancel the APAs in 2011. In this unusual memorandum opinion, the Court reaffirmed the established precedent that once an APA is in place, the IRS can cancel based on the revenue procedures or a breach of the material assumptions. A change of opinion on a technical matter is not sufficient to cause a cancellation.
This is good news for taxpayers looking to enter into the IRS' APA program, and achieve certainty on their transfer pricing positions going forward. This Tax Court memorandum reaffirms the position that it is difficult to for the IRS to cancel an APA, unless the company breaches a material assumption in the APA.
1 Eaton Corp. v Commissioner, T.C. Memo. 2017-147, T.C., No.5576-12, 7/26/17
The Apotex Case2 – using transfer pricing tools to settle drug infringement cases
Apotex manufactured a patent-protected drug in Canada, then sold it in Canada, Australia and the UK. It has been established that in 2008 Apotex infringed Servier's patent, and damages are to be paid.
This case looks at how to calculate the settlement based on Apotex's sale of the patent-infringing drug to the off-shore affiliates. Fundamentally, the Federal Court of Appeal answered two key questions.
To calculate the value of the loss suffered, Servier elected to claim the accounting profits earned from the sale of the infringing drug. The questions on appeal were, what are Apotex's profits from the export sales to affiliates and can the hypothetical purchase of a non-infringing drug be used to reduce the settlement?
Justice Dawson rejected the approach that Servier is entitled to all of the profits derived from the export sales. Instead, the “differential profit approach” is to be used where Servier is entitled to the profits which are “casually attributable” to the invention, potentially being the difference between the profits earned on the sale of the infringing and the non-infringing drug. This gives rise to the possibility that Apotex could point to a “hypothetical purchase” to reduce the settlement from the starting position, being the total profits earned.
The Federal Court had heard evidence from three third-party manufacturers based in India and Mexico, which established that Apotex may have been able to purchase a non-infringing version of the drug to resell to its affiliates, at the time the infringement took place. This hypothetical purchase can then be used to ascertain the profits casually attributable to the infringement of the patent.
The Federal Court of Appeal outlined the hypothetical purchase test, which is twofold: firstly, if the third-party manufacturer could have provided the non-infringing drug in the required quantity; secondly, if the first test failed, to then assess if at a later time, the manufacturer could have provided the non-infringing drug. From a transfer pricing perspective, the analysis is similar to using the Comparable Uncontrolled Price (CUP) method.
Once the Federal Court is satisfied that the third-party manufacturers could have supplied the non-infringing drug in the required quantities, the analysis would presumably then turn to quantifying the difference in the CUP analysis and actual profits earned. This case demonstrates that transfer pricing methodologies are not limited to tax cases, and the principles are easily utilized for other purposes.
The second question that has been put to the Federal Court of Appeal is, if the infringing drug price included both the cost of the drug and a legal indemnity (in case of patent infringement), can this indemnity also be used to reduce the profits payable to Servier?
Apotex had intercompany agreements with the offshore affiliates, which included the price payable for the supply of both the infringing and non-infringing drug. However, lacking was a price difference between the infringing and non-infringing drug. This was a fatal flaw in the agreement, which led Justice Dawson to conclude that there was no value demonstrated for the indemnity on the infringing drug. Therefore, there was no reduction in the profits earned by Apotex for the indemnity, which was provided to the affiliates.
Of note is the interpretation of the intercompany agreements. Agreements will be interpreted based on the “factual matrix,” which includes reviewing the contract and surrounding circumstances at the time of formation, on an objective basis. For example, if there is a difference in the price of two goods, the difference in value either needs to be specified in the contract, or clearly demonstrated in another way at the time the contract is put in place.
Justice Dawson noted that at the time the intercompany agreement was put in place, an important factor that could have been taken into account was the inability by the affiliates to bear the financial risk of patent infringement, which may have been a valid reason to support a price difference. This is a common scenario when companies first expand into a new jurisdiction. In this light, retrospective analysis or evidence to “support” a position taken, such as a price difference, is unlikely to be accepted by the courts.
This is an important reminder that intercompany agreements need to fairly reflect the intention of the parties, and should be regularly reviewed and amended to reflect the facts and circumstances at the time of entering into the contract. A lack of definition as to the underlying value of the goods or services included in a price, can result in specific components of the price being deemed valueless at a later date. The courts will continue to look to these intercompany agreements and surrounding facts to ascertain the nature of intercompany relationships, for both transfer pricing and other purposes.
2Apotex, Inc v Servier Canada, Inc,. Can Fed. C.A., 2/2/17, 2/2/17