A transfer pricing trial commenced on October 17, 2011, in the Tax Court of Canada in Toronto.  Mr. Justice Boyle is hearing the case on whether paragraph 247(2)(a) of the Income Tax Act (the “Act”) applies to the transaction at issue (the factoring of accounts receivable) to reduce the amount paid by a Canadian corporation to a non-resident affiliate which assumed the risks of collecting the Canadian corporation’s accounts receivable.  The agreed-upon discount rate was 2.2% but the Minister of National Revenue (the “Minister”) says it should have been just over 1%.  The trial is expected to take approximately 6-7 weeks of hearing time.  The hearing began on Monday with an opening statement by counsel for the Appellant, McKesson Canada Corporation (“McKesson Canada”).

McKesson Canada contracted to sell its accounts receivable to a related, non-resident company, McKesson International Holdings III S.à R.L. (“McKesson International”). McKesson Canada and McKesson International agreed to a variable discount rate that would be applied to the accounts receivable.  The rate was calculated using a formula that resulted in a discount rate of 2.2% for the 2003 taxation year.  According to the terms of the agreement, all bad debt risk relating to the accounts receivable that were sold was assumed by McKesson International. The discount rate was intended to compensate McKesson International for assuming the risk that some of the accounts receivable may not be collected and would have to be written off.

The Minister disallowed a portion of the amounts deducted by McKesson Canada in respect of the discount on the sale of accounts receivable. The Minister determined that, based on the terms and conditions in the agreement, the discount rate that would have been agreed upon had the parties dealt with one another at arm’s length would not have exceeded 1.0127%. Accordingly, the Minister added some $26 million to the Appellant’s income for its 2003 taxation year, reflecting a discount rate of 1.0127% rather than the rate of 2.2% as agreed by the parties.

In his opening statement, counsel for McKesson Canada contended that the issue should be whether the discount rate agreed upon by the parties was appropriate for an arm’s length transaction given the amount of risk that was being transferred from the vendor to the purchaser of the accounts receivable and that the issue should not be what the discount rate should be if the principal terms of the contract were changed to reflect some other hypothetical agreement used by the Minister for purposes of his assessment.  

In addition to the Part I appeal, there is a Part XIII appeal as well. The issue there is whether McKesson Canada conferred a benefit on its controlling shareholder, McKesson International, under subsection 15(1) of the Act by selling certain of it accounts receivable and, therefore, whether McKesson Canada should be deemed to have paid a dividend to McKesson International under paragraph 214(3)(a) of the Act. Including interest, the Part XIII assessment is approximately $1.9 million.

In conclusion, counsel for McKesson Canada argued that the Part XIII assessment is barred by virtue of the Canada-Luxembourg Income Tax Convention (1999) (the “Treaty”), which is applicable since McKesson International is a company existing under the laws of Luxembourg. As Article 9(3) of the Treaty includes a five year time limit for changes by Canada to the income of a taxpayer, the time for the adjustment expired on March 29, 2008 (before the Part XIII assessment was mailed).

The hearing continues.

For the link to the Part I Notice of Appeal, click here.

For the link to the Part I Amended Reply, click here.

For the link to the Part XIII Amended Notice of Appeal, click here.

For the link to the Part XIII Reply, click here.