Article 9 - Related Persons

Categories of Cloud-based services (p.132)

The models for providing cloud-based services have traditionally been divided into three categories: Software as a Service (SaaS), Platform as a Service (PaaS) and Infrastructure as a Service (laaS). SaaS offers ready-made applications for end-users. PaaS is more like an operating system, such as Microsoft Windows Azure, which allows the client to design applications with appropriate programming tools. ...

[I]ntegration Platform as a Service (iPaaS)… is a cloud integration platform, enabling connectivity to SaaS and other cloud services, and it offers a platform for SaaS users and cloud vendors to build and host packaged integration solutions which ensure that the data provided is available in a synchronized fashion across mobile, social and online mechanisms….

Disguised transfers of intangibles while under the Cloud (p.143)

[i]n the cloud it might be relatively easy to conceal a number of intangibles which would normally have to be transferred independently, especially if they are disguised as part of the overarching cloud infrastructure rather than as individual components transferred .within it….

[I]f more than just one intangible is transferred between S₁ and S₂ [two subs] while they are under the iPaaS "umbrella" it will be virtually impossible to evaluate each transfer separately because all of them will be integrated by the iPaaS and are also likely to derive most, if not all, of their functionality from being integrated by it. This difficulty will then trickle down to the next level affecting the choice of differing tax treatments of the respective individual subtransactions….

See also summary under Treaties – Art. 5.

Per OECD, Art. 9 permits recharacterizing debt where it is equity in economic substance (pp. 11176-7)

[T]he [Canada Revenue Agency] information circular [87-2R] notes that "Section 247 is intended to reflect the arm's length principle expressed in the OECD Guidelines." It also states the following:…

As a general rule, specific provisions of the Act—relating to loans and other indebtedness to or from non-residents, which are contained in sections 17 and 80.4, subsections 15(2) and 18(4)—would be applied before considering the more general provisions of section 247. These specific provisions deal with situations in which a Canadian corporate taxpayer:…

• is thinly capitalized

As noted in the CRA's information circular, the Canadian recharacterization provisions are intended to encompass the concept of recharacterization set out by the OECD in the 1995 transfer-pricing guidelines. The relevant portions of the guidelines (taken from the 2010 version) read as follows:…

[I]n other than exceptional cases, the tax administration should not disregard the actual transactions or substitute other transactions for them…

.

However, there are two particular circumstances in which it may, exceptionally, be both appropriate and legitimate for a tax administration to consider disregarding the structure adopted by a taxpayer in entering into a controlled transaction. The first circumstance arises where the economic substance of a transaction differs from its form….An example of this circumstance would be an investment in an associated enterprise in the form of interest-bearing debt when, at arm's length, having regard to the economic circumstance of the borrowing company, the investment would not be expected to be structured in this way….

The second circumstance arises where, while the form and substance of the transaction are the same, the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner and the actual structure practically impedes the tax administration from determining an appropriate transfer price. An example of this circumstance would be a sale under a long-term contract, for a lump sum payment, of unlimited entitlement to the intellectual property rights arising as a. result of future research for the term of the contract…

A non-resident parent's decision to (re)capitalize a Cdn. Sub lacks the attributes of an arm's length transaction, so that this unexceptional transaction should be addressed solely by the thin cap rule (p. 1192)

[R]egardless of the initial capital structure choices, it could be argued that it is always possible to recapitalize the Canadian subsidiary to the maximum extent permitted under subsection 18(4). A parent company's decision to capitalize a subsidiary corporation is not something that could (ever) be undertaken by arm's-length parties; this explains why the Act provides for annual testing of the deductibility of the subsidiary's interest under subsection 18(4) in accordance with the then-prevailing policy of the Department of Finance regarding the permitted debt-to-equity ratio.

Because the Canadian thin capitalization rules use an arbitrary ratio, there will necessarily be some winners and some losers on the basis of industry norms (leaving aside a treaty-based argument when a Canadian borrower is underleveraged by industry standards but otherwise restricted by the thin capitalization rules). We believe that there is a strong argument to be made when the Canadian borrower is overleveraged by industry standards (and there is no issue with the character of the equity), but is compliant with the thin capitalization rules, there is little scope for paragraph 247(2)(b) or (d) to adjust the nature of the interest payment on the intercompany debt. If this were not the case, the application of paragraph 247(2)(b) or (d) would have the effect of indirectly modifying the statutory ratio.

Would the arm's length version of a (recharacterized) transaction change post-implementation (p. 1201)?

[T]he CRA would not be concerned with an increase in the Canadian subsidiary's equity on account of greater retained earnings (regardless of their cause, whether better-than-expected market performance or improved operating conditions). It is therefore difficult to see why declines in the equity value on account of the inverse of these types of factors should matter (as long as they do not represent returns of capital to a non-resident shareholder).

In discussing advance pricing arrangements at paragraph 4.125 of the 2010 transfer-pricing guidelines, the OECD states that it would not be reasonable to assert that an arm's-length short-term borrowing rate for a certain company's intragroup debt would remain at the same rate during the entire term of an advance pricing arrangement. Similarly, regardless of the rationale for a particular capital structure when implemented, if the arm's-length version of the structure would have changed over time, the OECD's view can arguably be extended to require a dynamic approach to recharacterization.

After noting (at p. 171) that "the arm's length principle...tries to hypothesize its way around the economic integration of the firm," he stated:

Treating the firm's constituent and inextricable parts as if the composite entity were merely the sum of discrete transactions and dealings between independent actors is not a mere peccadillo. Ignoring the "firmness" of the firm has serious consequences. It not only fails to address directly the value of integration; equally important, it ignores the inescapable fact that many activities, relationships, and transactions occur within an MNE but never outside one.

A symptom of this latter problem appears in the recognition of the occasional need to "recharacterize" a transaction, as is permitted under the OECD guidelines where the transaction differs from what independent enterprises would do and it cannot be priced according to the arm's-length principle. [fn 36: OECD Transfer Pricing Guidelines, see for example, Organisation for Economic Co-operation and Development, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Paris: OECD, July 2010), at paragraph 4.8, and Canada Revenue Agency, Transfer Pricing Memorandum TPM-09, "Reasonable Efforts Under Section 247 of the Income Tax Act," September 18, 206, at paragraph 1:65] In such a case, the tax administration may disregard the actual transaction and recast it as the one that arm's-length parties would reasonably be expected to have done. [fn 37: Paragraph 247(2)(b) of the Canadian Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended, enacts a slightly different rule, substituting a "dominant tax benefit" test for the OECD's "unpriceability," although whether these are really different is a good question. The OECD guidelines do not refer to tax avoidance in this context, but the text seems to suggest it. What about bona fide commercial transactions that have no equivalent outside the MNE? If tax authorities can neither recharacterize transactions nor apply the arm's-length principle, what are they called upon to do?] In a simple comparison case (sale or lease, for example), this sounds almost plausible, but in most cases it is sophistry.

In the course of reviewing the background to Article 9(2) of the OECD Model Convention, they stated:

…According to Working Party 7, article 9 of the OECD Draft (1963) "serves a useful purpose as a statement of what Contracting Parties to Double Taxation Conventions have in Mind". From this statement, it may be concluded that the contracting states even intended to cover economic double taxation arising as a result of adjustments envisaged in article 9(1) of the OECD Model. Consequently, it is assumed that the contracting states had to make a corresponding adjustment, even without the inclusion of a separate provision for this. However, the United Stated initiated a targeted campaign with the intention of creating an international consensus relating to rules on corresponding adjustments. Accordingly, the second report of Working Party 7 resulted in a recommendation that the OECD Model provide for a corresponding adjustment to be made in all cases where profits had to be reallocated to one contracting state and where that state and the other contracting state agreed that the reallocation was fair. As the Committee agreed with the recommendation, article 9(2) was added to the OECD Model (1977). Against this background, however, if may be assumed that article 9(2) of the OECD Model is crucial with regard to the obligation to make a corresponding adjustment and, therefore, to prevent legally arising economic double taxation. In light of the amendment to the Commentary on Article 9 of the OECD Model (1992), such reasoning can, however, be disproved.…

In a further discussion of the OECD Discussion Draft on Transfer Pricing for Intangibles, he notes (at p. 935) that "transfer pricing rules — like the U.S. cost-sharing regulations — that permit the shifting of income-generating opportunities to affiliates based on the mere transfer of cash allow for the evisceration of a country's tax base through income shifting" (which he earlier referred to as amounting in the case of the US to perhaps $1.7 trillion) and refers to the fallacy that "transfers of intangibles between affiliates do not facilitate tax avoidance as long as the purchaser pays fair market value." He then states (at p. 935) that the OECD discussion draft combats these fallacies, as under its approach:

For a company to be treated as the earner of income from an intangible asset, the company must do something more than simply finance the development or purchase the asset. The OECD discussion draft proposes as this ‘‘something more'' a requirement that to claim the right to income from exploitation of an intangible, a taxpayer must, through active business activities, exercise control over the development and exploitation of the intangible.

After noting (at p. 285) that "under properly constructed transfer pricing rules...controlled entities should be treated as bearing the same risks they would bear if they were independent entities dealing with other businesses at arm's length," he goes on to note (at p. 276):

In the context of transfer pricing practice, important classes of risk-apportioning business arrangements include: (i) ‘‘limited risk'' distribution arrangements (including, in some instances, consignment and commissionaire arrangements) by which a group member, typically in a low-tax country, engages with a distributor to sell a product to unrelated parties in return for a fee or other limited return so that any residual profits or losses will inure to the lowtax party; (ii) contract manufacturing or similar arrangements, in which a group member, again typically in a low-tax country, arranges for an affiliate to perform manufacturing on a cost-plus or similar basis, so that residual profit or loss from the sale of the resulting product inures to the low-tax party; and (iii) service arrangements, in which a group member, also typically in a zero- or low-tax country, engages an affiliate on a cost-plus basis to develop potentially valuable intangibles, with any profits from use of the intangibles inuring to the low-tax affiliate. Much international tax practice today centers on setting up arrangements of those kinds. Through those arrangements, multinational groups recently have succeeded in shifting billions of dollars of potentially taxable profits into low- and zero-tax jurisdictions.

Adresses the following "myths" respecting the application of the CUP and CUT methods to intangibles: the CUP method cannot be applied because perfect comparables do not exist; global market information is not available; and redacted licence agreements have no value.

Respecting the discussion draft of the OECD's Working Party 6 recommending that the OECD adopt changes to its transfer pricing guidelines to envision that tax administrations develop safe harbour ranges of arm's-length margins and markups for use in benchmarking the incomes of relatively uncomplicated business operations conducted by members of multinational groups, Durst states (p. 647):

The discussion draft, in my view, responds in a sensible manner to some of the most common and serious practical difficulties that have arisen in transfer pricing practice over the past several decades. Attempting, over the years, to perform ‘‘from the ground up'' factual and comparables analyses for each individual business operation, regardless of its uniqueness or complexity has led to very large and in a great many cases prohibitive compliance costs. Despite the high costs incurred, however, the relative paucity of available comparables has caused comparable analyses to yield results that are too approximate and uncertain to be used by tax authorities in enforcement. [Footnote 2: These problems are demonstrated vividly by the deficient state of the contemporaneous documentation that taxpayers around the world are supposed to prepare to explain the detailed analyses that they are conducting. The head of transfer pricing at the OECD has observed that ‘‘transfer pricing documentation is some of the least informative literature that you will ever read.'' See ‘‘Andrus Favors Multilateral Approach to Safe Harbors, Simplified Documentation,'' Tax Mgmt. Transfer Pricing Rep. (Feb. 9, 2012)….]

Respecting paragraph 9 of the discussion draft, which states that countries might want to place some presumptive weight behind safe harbor ranges to facilitate enforcement, he states (p. 648):

Although this paragraph may seem discordant to some commentators, it must be remembered that transfer pricing rules are intended to constitute anti-avoidance tools for use in tax enforcement, and for anti-avoidance tools to be effective in practical application they must have some teeth. Long-standing experience has now made clear that requiring tax administrations to engage with taxpayers in case-by-case donnybrooks of detailed factual analysis, without the guidance of clear presumptions of some kind, simply is not realistic; requiring this approach has proven to be a recipe for tax anarchy rather than tax enforcement.

After quoting (at p. 448) the statement in the OECD discussion draft on transfer pricing for intangibles that "neither legal ownership, nor the bearing of costs related to intangible development... entitles an entity within an MNE group to retain the benefits or returns with respect to intangibles," Durst states:

For decades, many have apparently believed erroneously that under generally applicable principles of international tax law, bearing the financial costs of business activities entitles a party, for tax purposes, to income derived from those activities. That view is and always has been flatly incorrect. Working Party 6 already has performed a valuable service by correcting the apparently widespread misapprehension of this important point.

After stating (at p. 449) that "the discussion draft may be allowing a serious loophole in suggesting without additional clarification that control of R&D or other intangibles-creating activities can entitle a company to the residual income generated from successfully created intangibles," he states (at p. 450):

For a high-end contract R&D service provider, which has the sophistication required to develop potentially highly valuable intellectual property, to agree to do so for only fixed compensation would place the R&D provider at great economic risk. That R&D provider probably will demand a share in future income from developed intangibles as part of the compensation under its contracts. Indeed, it seems unlikely that for intangibles of potentially high value, contracts in which the party purchasing R&D services receives full residual rights to developed intangibles exist at arm's length....

Similarly, he states (at p. 450) that "the discussion draft gives the appearance — perhaps unintended — of acquiescing in the notion that when one related entity exercises control and another performs the actual intangibles-creating activities, the presumptively most reliable transfer pricing method under the arm's-length principles is for the party exercising control to retain the residual right to income from the resulting IP," and makes the following suggestion (also at p. 450):

If the arm's-length principle is to be applied properly, the relative contributions of those managing and those implementing intangibles-creating activities need to be determined so that an arm's-length division of income between the two can be determined. The best indicator of that arm's-length division of income normally will be the relative values that the multinational group itself places on the managers and on the implementers — that is, the relative values of their compensation. To prevent a continuation of massive income shifting through one-sided apportionments of income to entities where managerial functions are located, Chapter VI should make clear that in the absence of compelling evidence to the contrary, the relative compensation paid to personnel (including both managerial and operations personnel) performing services for the development of intangibles will be the most reliable indicator of the arm's-length division of income resulting from the successful exploitation of developed intangibles.