With "the predominant purpose...of...the reduction of its Canadian tax on its profits" (para. 18), the taxpayer, which was an indirect Canadian subsidiary of McKesson Corporation (a U.S. public company), entered into an agreement (the "RSA") for the sale of its trade receivables, as they arose (mostly from sales by it of pharmaceutical products to Canadian drug stores and hospitals), at a discount to its immediate Luxembourg parent ("MIH"). The initial receivable balance sold was $460M. The receivables were required to be sold on a serviced basis (with the taxpayer charging a fixed servicing fee which was not challenged) and on a non-recourse basis (except for the ability of MIH to put them back to the taxpayer for the amount collected by the taxpayer.) All receivables were sold at a fixed discount from their face amount of 2.206% (which worked out to an annualized rate of 27% given an average of 30 days until collection) and the Minister reassessed on the basis that the discount should be 1.013% (corresponding to an annualized effective financing rate of around 12.5%) thereby resulting in an upward transfer pricing adjustment to the taxpayer's 2003 taxation year (the first affected year) of $26.61M together with Part XIII tax on a deemed dividend based on a correlative conferral of a benefit on MIH.
In finding that the taxpayer's evidence did not make out a prima facie case to demolish the assumptions of fact underlying the Minister's choice of a 1.013% discount rate, so that the taxpayer's appeal was dismissed, Boyle J made the following findings and observations:
- The appropriate approach under ss. 247(2)(a) and (c) was "to follow the structure of the RSA that the McKesson Group chose to enter into…and consider whether the terms and conditions which affect the Discount Rate pricing differ from what arm's length terms and conditions would be expected to provide" (para. 270) – rather than to look at the pricing that would have applied to a different structure, e.g., a sale of the receivables on a recourse basis, with such recourse secured by a reserve (para. 166).
- Contrary to the actual terms, arm's length parties would have reduced the discount rate applied on the initially sold receivables to reflect that they were on average only 16 days away from being collected (paras. 70, 291).
- The component of the discount rate to reflect potential bad debt losses should be reduced so as to only reflect the historic loss performance of the taxpayer's receivables pool (of 0.04%) plus a 50% to 100% premium over this (increasing this component to 0.06% to 0.08%) to reflect a risk of this experience deteriorating (paras. 306, 311-312) – rather than using a much higher imputed loss rate based on the proposition that the sales customers did not have bond ratings ("I can not reasonably conclude that a company that does not have a bond rating can be assumed to be hiding a bad implicit rating from the public" (para. 298, see also para. 245).)
- Only a modest additional discount (of 0.17% to 0.25%) would be needed to account for a risk that an arm's length purchaser might have to incur additional costs to hire a replacement servicer if a termination event occurred and the taxpayer no longer was suitable (para. 333).
- Although it was odd that "the parties to the RSA provided that prompt payment discounts are not treated as deemed receipts but are instead at the purchaser's risk," Boyle J accepted "that arm's length parties might agree to such a term" (para. 334). However, rather than their agreeing to a fixed discount spread to reflect the risk that an increasing number of customers would take prompt-payment discounts (as was done here), they would instead adopt "a three or four month, or annual floating dynamic payment component to the Discount Spread component…to fully capture…the risk of change" (para. 338).
- The interest discount should not be increased by an assumed cost of funds that would be associated with MIH financing 100% of the purchase price by issuing junk bonds, as there was no basis to suggest that the taxpayer would be driven to seek receivables financing from a high cost factoring company rather than a major financial player. Adding a modest additional interest discount of 0.0% to 0.08% (reflecting the investment grade credit rating of the US parent) was appropriate (para. 349).
- The Court…should consider "notional continued control type rights in appropriate circumstances," as "if these were to be ignored ... companies within wholly controlled corporate groups could enter into skeletal agreements conferring few rights and obligations to the non-resident participant ... all with the view to obtaining a more favourable transfer price..." (para. 132).
Extract from 10K of McKesson Corporation for year ended 31 March 2015
We have received reassessments from the Canada Revenue Agency ("CRA") related to a transfer pricing matter impacting years 2003 through 2010, and have filed Notices of Appeal to the Tax Court of Canada for all of these years. On December 13, 2013, the Tax Court of Canada dismissed our appeal of the 2003 reassessment and we have filed a Notice of Appeal to the Federal Court of Appeal regarding this tax year. After the close of 2015, we reached an agreement in principle with the CRA to settle the transfer pricing matter for years 2003 through 2010. Since the agreement in principle did not occur within 2015, we have not reflected this potential settlement in our 2015 financial statements. We will record the final settlement amount in a subsequent quarter and do not expect it to have a material impact to income tax expense.