The recent decision of the Tax Court of Canada in Marzen Artistic Aluminum Ltd v R1 is one of the first cases to expressly consider whether documents produced by a taxpayer constitute adequate "contemporaneous documentation" for the purposes avoiding the imposition of transfer pricing penalties under the Income Tax Act (the "ITA").
Under section 247 of the ITA, the Canada Revenue Agency ("CRA") can adjust the terms and conditions of cross-border transactions between a Canadian taxpayer and a non-arm's length party where such terms and conditions are not "arm's length". Where the CRA makes such a transfer pricing adjustment, the taxpayer is potentially subject to a penalty equal to 10% of the full amount of the adjustment (or $5 million, whichever is less), unless the taxpayer shows that it made reasonable efforts to determine and use an arm's length transfer price.
Crucially, however, subsection 247(4) deems a taxpayer not to have made reasonable efforts to determine and use an arm's length transfer price unless it has made or obtained "contemporaneous documentation" described in that subsection and updates such documentation, as needed, in subsequent taxation years. Proper contemporaneous documentation must provide an accurate description of:
- the property or services to which the transaction relates;
- the terms and conditions of the transaction, and their relationship (if any) to the terms and conditions of other transactions between the parties;
- the identity of the parties to the transaction and their relationship to each other;
- the functions performed, the property used or contributed or the risk assumed by the parties in respect of the transaction;
- the data and methods considered and the analysis performed to determine the appropriate transfer price ("Data and Analysis"); and
- the assumptions, strategies and polices, if any, that influenced the determination of the appropriate transfer price ("Assumptions and Policies').
The Marzen Decision
The facts in Marzen are convoluted, but at a high level, the case involved a fairly blatant (and ultimately unsuccessful) attempt by a Canadian corporation to shift income from Canada to its Barbados subsidiary. The CRA (successfully) reassessed the taxpayer and levied a transfer pricing penalty of approximately $500,000 on the basis that the taxpayer had failed to prepare (and provide) contemporaneous documentation.
At trial, the taxpayer argued that it had provided "contemporaneous documentation" in the form of (i) the relevant intercompany agreements, (ii) certain correspondence between the parties relating to certain elements of the transaction, and (iii) a business study prepared by one of the promoters of the business structure. Unfortunately for the taxpayer, Justice Sheridan rejected that submission, noting that the taxpayer "failed to provide records or documentation that fulfill the requirements of paragraph 247(4)(a) and specifically that the documents and records submitted by the taxpayer are not sufficient to satisfy subparagraphs 247(4)(a)(v) and (vi)", namely the Data and Analysis and Assumptions and Policies supporting the terms and conditions of the impugned transactions. As a result, the Court upheld the CRA's imposition of penalties on the taxpayer
Implications of the Marzen Decision
Apart from emphasizing the importance of ensuring that cross-border transactions with non-arm's length parties be conducted on arm's length terms, the Marzen decision also suggests that strict compliance with the "contemporaneous documentation" requirements in subsection 247(4) is required in order to avoid the imposition of transfer pricing penalties.
In particular, in order to satisfy the contemporaneous documentation requirement, documents prepared by taxpayers must fulfill all of the requirements contained in paragraph 247(4)(a). Among other things, they must document their Data and Analysis and Assumptions and Policies described in subparagraphs 247(a)(v) and (vi) on which their transfer pricing was based. Since the information described in those paragraphs typically goes beyond what would be contained in typical intercompany agreements and commercial discussions, taxpayers will need to make a conscious effort, and may need to seek expert advice, in order to satisfy these requirements.
It has recently been suggested that, heretofore, CRA practice as to what constitutes acceptable "contemporaneous documentation" has been somewhat lax.2 In light of the Marzen decision, and the increasingly aggressive tenor of the CRA in dealing with transfer pricing issues generally, taxpayers should expect that the CRA will, in the future, require that contemporaneous documentation strictly adhere to the requirements set out in subsection 247(4) and should ensure that their contemporaneous documentation satisfies those requirements.