International Tax Panorama

Introduction: 

Transfer pricing is one of the most controversial tax issues facing corporations that operate globally. One such cases that was long-awaiting its decision was that of Cameco Corporation v. The Queen, which received its verdict on September 26, 2018 by The Tax Court of Canada. Cameco case is a precedent setting decision involving key transfer pricing principles that many countries have incorporated into their domestic taxing statutes. It will reverberate as a shock to governments and as a relief to multinational enterprises. 

The dispute focused on Cameco’s marketing and trading structure involving foreign subsidiaries and the related transfer pricing methodology used for certain inter company uranium sale and purchase agreements. The Court held that Cameco paid arm’s length prices on intercompany transfers of uranium to a wholly-owned Swiss subsidiary pursuant to long-term intercompany contracts. Thus Cameco’s marketing and trading structure involving foreign subsidiaries and the related transfer pricing methodology used for intercompany uranium transactions are in full compliance with Canadian laws, based on 2003, 2005 and 2006 tax returns.

Facts of the Case: 

Cameco Corporation is the world’s largest uranium producer and has its headquarters in Saskatoon, Canada (“Cameco Canada”). Prior to a reorganization, Cameco had uranium mines in Saskatchewan and uranium refinery and conversion facilities in Ontario. Cameco’s US subsidiary owned uranium mines in the United States (US).

Reorganisation of Cameco:

During the early 1990s, Cameco decided to reorganize itself. Following the reorganization, the Cameco Group had three main entities which are as follows:   

• The Canadian entity, which continued to operate uranium mines and conversion facilities in Canada along with providing administrative support services to other Cameco entities,
• CESA/CEL, a Swiss entity that was the trader for the group, purchasing and selling uranium from Russia and the Canadian and US affiliates. It had two employees to perform duties that included the conclusion of new uranium contracts (approx. 20-25 per year) ; and 
• Cameco US, which was the marketing arm responsible for selling the uranium to third parties for use in nuclear reactors.

Inter-company transactions between Cameco Canada and CESA/CEL (Swiss Cameco): 

CESA/CEL was the wholly owned Swiss subsidiary of Cameco Canada. It had following forms of inter-company transactions :

• Administrative Services: Under a services agreement, Cameco Canada provided administrative services to Swiss Cameco, for which it was compensated.

• Financial Guarantees: Cameco Canada also provided guarantees to arm’s length parties with respect to financial agreements they entered into with Swiss Cameco. Swiss Cameco paid Cameco Canada guarantee fees for these services. 

• Long- term Contracts with respect to sale & delivery of Uranium:

Beginning in 1999, Cameco entered into a series of long-term contracts for the sale of uranium to its Swissco. These private long term contracts was in tandem with the Uranium industry as Uranium is not listed on an exchange but is bought and sold under private contracts — spot or long-term. 

Pricing Mechanism under the various contracts: 

Uranium contracts follow four types of pricing mechanisms:  fixed pricing, base-escalated pricing, market-related pricing and hybrid pricing. 

• Agreements based on Base-escalated pricing model (1999 to 2001): CESA/CEL entered into nine long-term agreements with Cameco. Under the agreements, CESA/CEL was to receive uranium from Cameco, most of which used the base-escalated pricing model (the BPC transactions). 

• Agreements based on Fixed/ Market-based pricing model (1999 to 2006): CESA/CEL and Cameco entered into 22 agreements to deliver uranium to Cameco on a specific date or short-term delivery period that used a fixed or market-based price (the CC transactions and, collectively, the transactions).

The base price for contracts with fixed price terms and base escalated pricing mechanisms ranged from $8.25 to $33.00 a pound, depending on the contract and applicable year. The contracts with market based pricing mechanisms included ceiling prices ranging from $11.00 to $12.50 a pound.

All of the contracts included flex options that ranged from plus or minus 20% to 30% of the quantity deliverable under the contract.

Subsequently, Swiss Cameco bought uranium from Cameco Canada at the contract prices and sold it to Cameco US close to its market price, which usually surpassed the contract prices, sometimes very significantly. Swiss Cameco kept all the revenue from its uranium sales.  Cameco US then sold the uranium to end customers at market prices. Following the entering into of these supply contracts, the price of uranium rose significantly. The result was that profits from sales by the Swiss subsidiary to customers outside of Canada were realized largely in Switzerland rather than Canada.

Journey of the Dispute: 

Coming under CRA’s radar in 2008: The Cameco dispute reaches back to 2008, when the Canada Revenue Agency took issue with Cameco’s corporate structure and the pricing methodology the company used in uranium sale and purchase agreements with its Swiss-based subsidiary.

The CRA challenged that, arguing the Canadian operation substantially understated its taxable income and should be reassessed under the sham doctrine because the Swiss company wasn’t engaged in the uranium business.The tax authorities maintained that the inter-company transactions were commercially unreasonable and undertaken only to achieve a tax benefit and were abusive.

Reassessment of Cameco by The Canadian Revenue Agency (CRA): The Canadian Revenue Agency (CRA) later reassessed Cameco for its 2003, 2005, and 2006 tax years to effectively attribute to Cameco the foregone profits for the purposes of computing its Canadian income tax liability.

Although the case before the Tax Court only involved three tax years, the CRA had also reassessed Cameco on the same basis for subsequent tax years, such that Cameco’s potential tax exposure would have been approximately CAD 2 billion (≈ USD 1.5 billion) in taxes, plus interest and penalties. The CRA was to shift more than $7 billion in earnings back to Canada for tax years 2003 to 2015.

Defending the reassessments by the CRA: 

The CRA defended the reassessments on following grounds:

1. Sham Transaction: First, the CRA took the position that the inter-company purchase and sale agreements were a sham and should be disregarded.The Crown claims that SwissCo did not operate a uranium buying and selling business but was an empty shell with the sole purpose of facilitating the transfer of profits from Canada to Switzerland.

• Key decision making performed by Cameco Canada: The CRA argued that all of the important functions and all of the strategic decisions in respect of the Cameco group’s uranium-trading business were performed and made by Cameco in Canada, and the intercompany transactions gave the appearance that Swiss Cameco was doing the work. The CRA said that this was done so that Cameco Canada could record its profits in Switzerland instead of Canada, thereby minimizing its Canadian taxes.

• No/ few employees in SwissCo: The CRA alleged that SwissCo did not have the staff required to effectively carry out a business of buying and selling uranium. 

In the analysis of a sham, the CRA asserts that it is necessary to determine what actually happened rather than what appears to have happened. According to the CRA, examining the documents alone is not sufficient to evaluate a sham, because the documents are how the sham was implemented. In other words, the court should look beyond the documentation submitted during the trial.

2. Application of recharacterization rules:

The Minister’s second position rested on the transfer pricing provisions found in paragraphs 247(2)(b) and (d) of the Income Tax Act.  The Minister argued that the transactions between Cameco Canada and Swiss Cameco differed from transactions that would have been made between persons dealing at arm’s length and were not entered into primarily for bona fide purposes other than to avoid Canadian taxes on income from uranium sales. Therefore, those transactions should be disregarded and all of Swiss Cameco’s revenue should be attributed to Cameco Canada.

3. Application of traditional transfer pricing provisions:

The Minister’s third position rested on the more traditional transfer pricing provisions found in paragraphs 247(2)(a) and (c) of the Income Tax Act.  The Minister argued that if arm’s length parties would have entered into the challenged transactions, then the terms or conditions made between Cameco Canada and Swiss Cameco were not what arm’s length parties would have made.  Essentially, Cameco Canada did not charge Swiss Cameco enough for the uranium it sold to it.

Decision :

In a lengthy 286-page judgment, the Tax Court conducted a careful review of the relevant facts and applicable law and concluded that the transactions were not a sham and did not violate the arm’s length standard contained in Canada’s domestic transfer pricing rules.

The Court rejected all three of the Minister’s positions. In essence, the Court did not agree with the Minister that Cameco had improperly shifted its profits to Switzerland in order to reduce its Canadian tax liabilities.

1. No involvement of Sham transaction: 

Legal relationships as sufficient proof of parties’ true intentions: The Court found that there was no sham in this case and that the appellant, Cameco US and CESA/CEL entered into numerous contracts to create the legal relationships described in those contracts, and that there was no evidence to suggest that those contracts (between 1999 and the end of 2006) did not reject the parties’ true intentions to those contracts. While those arrangements may have been tax related, a tax motivation does not transform the arrangements into a sham.

Nothing unusual about the operation of the Cameco Group as a whole: The Court also found that the fact that the boards of CESA and CEL approved of transactions in the best interests of the Cameco Group as a whole did not detract from the legitimacy of their role in directing the affairs of CESA/CEL, and that “[n]o reasonable person would expect a wholly owned subsidiary to act in a manner that is at odds with the interests of the ultimate parent corporation or of the broader corporate group.”Further, the Court noted that the foreign affiliate regime in the Act contemplates Canadian corporations establishing subsidiaries abroad to carry on active businesses in those jurisdictions, and the purpose of the regime is to allow Canadian multinationals to compete in international markets through foreign subsidiaries without attracting Canadian income tax. The Court found that the way that the Cameco Group operated was reasonable and that “there was nothing unusual about the way the Cameco Group operated.”

2. First decision on Transfer pricing recharacterization rule:

The Court highlighted that this was the first decision where the transfer pricing recharacterization rule (TPRR) in paragraphs 247(2)(b) and (d) was being considered. 

Meeting the qualification test: Prior to interpreting the TPRR, the Court noted that section 247 does not apply to a transaction or a series between a taxpayer and one or more arm’s-length persons, or to a transaction or a series between two nonresidents where neither is a taxpayer. However, the existence of such a transaction or series, and the terms and conditions of that transaction or series, may be relevant facts when applying the TPRR to a transaction or series between a taxpayer and a non-arm’s- length nonresident.

The Recharacterization Rule application : 

In order to apply recharacterization rule, following tests must be fulfilled:

• Fulfilment of two-pronged test under Paragraph 247(2)(b): 

Par. 247(2)(b) applies where: (i) the transaction or series would not have been entered into by arm’s-length parties; and (ii) the transaction or series can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit. 

Transaction/Series must be commercially irrational: In determining whether subparagraph 247(2)(b)(i) is met, the Court held that the focus is on whether the transaction or series would have been entered into by arm’s-length persons acting in a commercially rational manner. Therefore, the test will be satisfied if it is found that the transaction or series is not commercially rational, and such an objective assessment of the transaction or series may be aided by expert opinion. 

Primary purpose of the Transaction/Series must be to obtain tax benefit:  In determining whether subparagraph 247(2)(b)(ii) has been satisfied, the Court stated that it will be met where, upon an objective assessment of the driving forces behind the transaction or series, it is reasonable to consider that the transaction or series was not entered into primarily for bonafide purposes other than to obtain a tax benefit.

• Subsequent application of Recharacterization Rule (Par. 247(2)(d)):

The Court indicated that if the two-pronged test in paragraph 247(2)(b) is satisfied, then the Minister may apply paragraph 247(2)(d) or referred to as the recharacterization rule. 

No Actual recharacterization / disregard of the Transaction/Series: In the Court’s view, the rule does not permit the Minister to recharacterize the transaction or series identified, nor does it allow the Minister to simply disregard the transactions as if nothing in fact occurred. Rather, subsection 247(2) permits the Minister to identify an alternative transaction or series that in the same circumstances would be entered into by arm’s-length parties in place of those entered into and then to make an adjustment that rejects arm’s-length terms and conditions for that alternative transaction or series. This adjustment, being based on arm’s-length terms and conditions, may alter the quantum or the nature of an amount.

Testing against four series of transaction against one set: While the Court rejected the Crown’s assertion that all of the transactions undertaken by Cameco and/or CESA/CEL since the reorganization in 1999 are part of a single set of transactions that must be tested against the transfer pricing rules, the Court identified four series of transactions. In essence, these consisted of the  following:

• incorporation of CESA/CEL, 
• the designation of CESA/CEL as the signatory to the Tenex Agreement and Urenco Agreement, 
• Cameco’s guarantee of the obligations of CESA/CEL under those agreements (collectively, the series) and 
• the entering into by CESA/CEL to receive uranium from Cameco (the BPC transactions) and to deliver uranium to Cameco (the CC transactions and, collectively, the transactions).

Application of Recharacterization rule to the facts of the case: 

• Meeting the qualification test: The Court found that the conditions in the preamble of subsection 247(2) were satisfied. Cameco is a taxpayer, and CESA/CEL and Cameco US are non-arm’s-length nonresidents that were the participants in a series of transactions. 

• The Transactions were Commercially Rational (Par. 247(2)(b)(i)): 

Appropriate compensation with forgoing business opportunity: In determining whether the first prong of the test in paragraph 247(2)(b) was met for the series, the Court concluded that it would be commercially rational for a party to give up a business opportunity, so long as it received the appropriate compensation for such an opportunity (such an analysis is governed by paragraphs 247(2)(a) and (c)). Here, for Cameco to conclude the Tenex Agreement and Urenco Agreement, it was necessary to involve the participation of two competitors, since each party gave up a business opportunity to achieve other objectives.

Contractual arrangement in consonance with Industry practices and Commercial reality: With respect to the transactions, the Court found that the BPC transactions were long-term contracts, the duration of which was within the range of the long-term contracts for that period, that were for volumes of uranium that were reasonable when compared to arm’s-length wholesale contracts made during the same period, and that provided Cameco with an appropriate level of compensation. Given that commodity producers will sell production under a base-escalated contract to secure a guaranteed revenue stream for that production even if the price is expected to move higher, the Court found that the transactions were not the type described in subparagraph 247(2)(b)(i) of the Act. Similarly, with respect to the CC transactions, the Court found that there was nothing commercially irrational about the contracts since they were for a single delivery of uranium or deliveries over a short period of time and were based on a fixed price or a market-based price.

• Transaction/Series entered into primarily for bonafide-purposes (Par.247(2)(b)(ii)): While the Court concluded that the first prong of the test in paragraph 247(2)(b) had not been met, the Court went on to consider the application of subparagraph 247(2)(b)(ii).

Although the Court held that the primary purpose of the series was to save the tax that would have been payable in Canada had Cameco entered into those agreements directly, the Court distinguished between the primary purpose of the series and that of the transactions. The purpose of the transactions simply did not follow the primary purpose of the series. The transactions entered into between CESA/CEL and Cameco were for the bona fide purpose of earning a profit. Consequently, the transactions did not meet the second prong of the test in paragraph 247(2)(b).

3. No Transfer Pricing adjustment warranted under Par. 247(a) and (c) : Finally, the Court considered the application of paragraphs 247(2)(a) and (c) (referred to as the “traditional transfer pricing rules”) to the series and transactions — the price that would have been paid in the same circumstances had the parties been dealing at arm’s length. 

• No Economic benefit through participation for the Appellate: With respect to the Tenex Agreement, the Court found based on the evidence (such as the conclusion of an agreement with two competitors and the purpose of the agreement to prevent the market being flooded with uranium) that the economic benefit of participating in the agreement at the time of execution was negligible and that any economic benefit would depend on uncertain future events. Consequently, the Court rejected any adjustment with regard to the appellant on the basis of the series of transactions leading to the Tenex Agreement.

• Accrual of compensation commensurate with the economic benefit for Cameco US: With respect to the Urenco Agreement, the Court found that the objective of the agreement was to avoid Urenco dumping uranium onto the market, depressing its price, and to provide a trading opportunity to CESA/CEL. While Cameco US led the negotiation of the agreement on behalf of CESA/CEL, this did not automatically lead to a transfer pricing adjustment. Such an adjustment would depend on the compensation to Cameco US. Given that Cameco US also benefitted from the agreement with Urenco because of its 2% commission, the Court held that it was unlikely such a transfer pricing issue exists. Similar to the Tenex Agreement, the Court concluded that there was no evidence to support a different view regarding the value of the Urenco Agreement, given that it was negotiated by arm’s-length parties and since it represented the possibility that CESA/CEL could earn a profit by purchasing Urenco’s uranium.

• Non application of traditional transfer pricing rules to recast arrangements: Importantly, the Court also held that price risk associated with the commodity transactions (and commensurate remuneration for such risk — which, according to the Crown, should have represented the majority of CESA/CEL’s profit from the purchase and sale of uranium) cannot be shifted simply because a related party (Cameco Canada) provided support and other services under a contract for services. The Court noted that the traditional transfer pricing rules must not be used to recast the arrangements actually made among the participants in the transaction or series, except to the limited extent necessary to properly price the transaction or series by reference to objective benchmarks.

4. Appropriate Pricing Methodology : The Court held that for both transactions the comparable uncontrolled price (CUP) methodology was the most reliable transfer pricing methodology to test the price charged under those contracts. However, under the CUP methodology, the Court held that the terms and conditions of the transactions were those that arm’s-length parties would have entered into given the circumstances. Based on Cameco’s experts’ analyses, it found that the transaction pricing, absent hindsight, was well within the arm’s-length range.

Thus The Court found in favour of Cameco, dismissing the main arguments presented by the CRA and concluding that the transactions and events surrounding the years in question

(1) were not a sham, (2) were carried out for the bona fide purpose of earning profit, and (3) had terms and conditions that would have transpired between arm’s- length parties under the same or similar circumstances. Consequently, the transfer pricing reassessments for each of the taxation years were dismissed.

Implications of the decision: 

• Reigniting the Form vs Substance debate: 

The case cuts to the heart of the ever recurring debate about form versus substance in transfer pricing cases. After Cameco’s win it can be said that the “form” argument prevails, setting a precedent whereby it will likely be easier for Canadian taxpayers to rely on legal documentation and paperwork to support their positions in future disputes with the CRA’s auditors.

It also equips Canadian taxpayers with an important tool to argue that the CRA auditors must respect the form of their transactions and should not attempt to look beyond the written documents in order to develop a version of the facts that may contradict the formal documents.

The respect of the form over the economics of a transaction stems from a central principle in Canadian tax law that taxpayers are entitled to arrange their affairs so as to minimize tax liability. Therefore, as long as the legal form is not deceitful (i.e., the legal effects of a transaction are the same that its form suggests), a transaction will usually not be recharacterized for purposes of the tax law.

• First case to consider the re-characterization rule of Canadian transfer pricing legislation:

It’s the first tax case to consider the second branch of the Canadian transfer pricing rules, under s. 247(2)(b) of the Income Tax Act transfer pricing rules.

One of the research data demonstrates that, although recharacterization cases are much less common than cases involving purely adjustments to the pricing of the transaction (under Par. 247(2)(a) and (c)), recharacterization has been on the radar of CRA auditors for use on a select number of cases. However the court’s decision has made it harder for the CRA auditors to argue that inter company transactions as structured by the taxpayer can be redesigned under a CRA audit, in order for the transaction to be consistent with CRA’s interpretation of the substance.

Future course of action: 

The court has referred the matter back to the Minister of National Revenue in order to issue new reassessments for the 2003, 2005 and 2006 tax years in accordance with the court’s decision. The timing for the issuance of the revised reassessments along with refunds plus interest is uncertain.

CRA has 30 days from the date of the decision to appeal to the Federal Court of Appeal. If appealed, Cameco estimates it would take about two years for the Federal Court of Appeal to hear and decide the matter.

Decisions of the Federal Court of Appeal may be appealed to the Supreme Court of Canada, but only if the Supreme Court agrees to hear the appeal. If an appeal to the Supreme Court is pursued, Cameco estimates that a further two years would be required to receive a decision.

On the other hand Cameco will be making an application to the court to recover the substantial costs incurred over the course of this case.

Conclusion: 

The decision will likely have a profound impact on the future of tax planning as well as on tax and transfer pricing audits in Canada. The case will likely become a critical source of reference for the application or not of the sham doctrine, for the very important transfer pricing recharacterization provisions , and on cases involving the “form vs. substance” dilemma.

 

References:

Cameco Corporation v The Queen, 2018 TCC 195

¹https://www.eylaw.ca/Publication/vwLUAssets/Tax_Alert_2018_No_33/$FILE/TaxAlert2018No33.pdf

²https://www.lawtimesnews.com/author/jim-middlemiss/cameco-and-oxford-cases-front-and-centre-in-2018-15243/

³https://www.lawtimesnews.com/author/jim-middlemiss/cameco-and-oxford-cases-front-and-centre-in-2018-15243/

⁴Richter LLP recently obtained data from the CRA’s Transfer Pricing Review Committee (TPRC) including the number of recharacterization referrals that were made by CRA auditors on an annual basis from January 2012 to April 2017. The total number of referrals was 39 and the average annual number was seven (excluding the 2017 partial year). CRA policy requires that its auditors obtain authorization from the TPRC in order to proceed with reassessments based on the recharacterization provisions of the Act.

The TPRC figures also indicate the number of transfer pricing cases referred to it for application of penalties as a result of adjustments to the pricing of the transactions under ¶247(2)(a) and (c). From January 2012 to April 2017, the total number of transfer pricing referrals by CRA auditors was 325, and the average was 60 per year.

https://www.richter.ca/news-media/the-precedent-setting-cameco-case-concluding-remarks-on-trial-show-fierce-battle-on-key-tax-and-transfer-pricing-issues/

⁵https://www.law.com/legalnewswire/news.php?id=908793