Written by Michael Clough, Jerome Tse, John Boyagi and David Blight.
Last week, the Canadian Federal Court of Appeal (the Court) dismissed an appeal by the Canada Revenue Agency (the CRA) in favour of uranium mining and trading giant Cameco Corporation (Cameco).[1]
The Court ruled that Cameco and its offshore subsidiaries had not fallen foul of Canada's transfer pricing rules in relation to the sale and purchase of uranium and associated rights in 2003, 2005 and 2006.
- The Court held that the CRA is permitted to make transfer pricing adjustments by substituting one transaction or structure in its entirety for another in very limited circumstances, namely, when the disputed transaction "would not have been entered into between any two (or more) persons dealing at arm's length, under any terms or conditions".
- The Court set a high bar for permissible recharacterisation of transactions in a transfer pricing context. If the Cameco approach is endorsed in Australian Courts, the Commissioner of Taxation (Commissioner) may be subject to a similarly high bar should he wish to recharacterise entire cross-border transactions for the purposes of making transfer pricing adjustments.
- In light of the Court's reliance on OECD Transfer Pricing Guidelines (OECD Guidelines) in Cameco and given the increased importance that taxpayers are placing on mutual agreement procedures and mandatory arbitration through the Multilateral Instrument, Cameco serves as a reminder of the increased significance of the OECD Guidelines (including the outcomes under the OECD BEPS Project) in a transfer pricing context.
- Multinational businesses operating in Australia should keep a close eye on whether Australian Courts are willing to construe Australian tax legislation consistently with the OECD Guidelines to the same extent as the Court did in Cameco.
The decision in Cameco – an overview
The Cameco decision related to a series of transactions between Cameco, its offshore subsidiaries and several third parties. In summary, Cameco incorporated offshore subsidiaries which purchased uranium from third parties (and also from Cameco) for the purpose of resale. When the price of uranium surged, these subsidiaries realised substantial profits on the sale of the uranium.
One of the core propositions put forward by the CRA in Cameco was that, in arm's length circumstances, Cameco would have purchased uranium directly from third parties and sold directly to customers without its subsidiaries interposed in the economic chain, meaning Cameco would have realised the profits in Canada. As a result, the CRA reassessed Cameco's income based on hypothetical transactions that did not involve interposed subsidiaries – in other words, the CRA recharacterised (some would say annihilated) the transactions in their entirety.
The relevant Canadian transfer pricing provisions
The CRA purported to reallocate the profits of the subsidiaries to Cameco in part by relying on paragraphs 247(2)(b) and (d) of the Canadian Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (the Canadian Act). Under these provisions, where a taxpayer and a non-resident do not deal at arm's length in relation to a transaction, and where (among other criteria) that transaction "would not have been entered into between persons dealing at arm's length", the CRA is permitted to make a transfer pricing adjustment by replacing the actual transaction with a hypothetical transaction that would have been entered by persons dealing at arm's length.
The recharacterisation provisions in paragraphs 247(2)(b) and (d) are broadly analogous to the Australian provisions in sections 815-130(2) and (3) of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) i.e. the 'exceptions' to the basic rule that the hypothetical "arm's length conditions" must be based on the "commercial or financial relations in connection with which the actual conditions operate" and must "have regard to both the form and substance of those relations".
The decision of the Court in Cameco
The Court held that the CRA had erroneously recharacterised the Cameco transactions based on a flawed understanding of paragraphs 247(2)(b) and (d) of the Canadian Act. According to the Court:
- these provisions require an analysis of whether hypothetical parties dealing at arm's length would have entered into the transaction, as opposed to an analysis of whether the particular taxpayer (i.e. Cameco) would have entered into the same transaction under arm's length dealings; and
- the test is only satisfied "when no arm's length persons would have entered into the transaction … under any terms and conditions".
The Court relied on the 1995 OECD Transfer Pricing Guidelines (1995 Guidelines) to hold that these provisions apply in limited circumstances. In particular:
In other than exceptional cases, the tax administration should not disregard the actual transactions or substitute other transactions for them. Restructuring of legitimate business transactions would be a wholly arbitrary exercise the inequity of which could be compounded by double taxation created where the other tax administration does not share the same views as to how the transaction should be structured.
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... 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.
Based in part on its interpretation of the 1995 Guidelines, the Court appears to have imposed a very high bar for the CRA to be able to depart too far from the circumstances of the actual transaction.
In Cameco, the transactions in question were the buying and selling of uranium and associated rights. These were transactions which could be priced, and one cannot say that no arm's length parties would enter such transactions. According to the Court, the CRA was not permitted to make transfer pricing adjustments based on replacing these actual transactions with alternative hypothetical transactions that ignored (or annihilated) the existence of offshore subsidiaries. In doing so, the Court referenced 2010 OECD Transfer Pricing Guidelines that:
where one element of a restructuring involves the actual relocation of substantive business functions, any recharacterisation of the restructuring cannot ignore the fact that those functions were actually relocated.
The Australian context
The Australian legislative context – recharacterisation under Subdivision 815-B
The transfer pricing provisions in Subdivision 815-B of the ITAA 1997 operate to negate any "transfer pricing benefit" which arises when the "conditions that operate" between related parties diverge from the "arms-length conditions", being "the conditions that might be expected to operate between independent entities dealing wholly independently with one another in comparable circumstances".
Under section 815-130 of the ITAA 1997, the hypothetical "arm's length conditions" must be based on the "commercial or financial relations in connection with which the actual conditions operate" and must "have regard to both the form and substance of those relations", except in the following circumstances:
- the form of those relations must be disregarded to the extent it is inconsistent with the substance of those relations (subsection 815-130(2));
- if independent parties dealing wholly independently of one another in comparable circumstances would have entered into different relations than they actually did, the arm's length conditions must be based on arm's length relations (subsection 815-130(3)); and
- if independent parties dealing wholly independently of one another in comparable circumstances would not have entered into any relations, the arm's length conditions must be based on the lack of those relations (subsection 815-130(4)).
As such, the Australian provisions (at least in relation to the first two bullet points above) are in some respects analogous to the Canadian provisions discussed above, in that they appear to state that any transfer pricing adjustment should be based as closely as possible on the actual transaction or structure entered into by the relevant entities, except in exceptional circumstances.
The Australian transfer pricing provisions allow regard to be had to the 2017 OECD Transfer Pricing Guidelines (2017 Guidelines), which continue the theme set in the 1995 (and subsequent) OECD Guidelines in relation to recharacterisation of the actual transaction. The 2017 Guidelines state that every effort should be made to determine pricing for the actual transaction entered, except in circumstances where it is not possible to determine a price based on the actual transaction. Paragraph 1.122 of the 2017 Guidelines are instructive in this regard:
The transaction as accurately delineated may be disregarded, and if appropriate, replaced by an alternative transaction, where 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 in comparable circumstances, thereby preventing determination of a price that would be acceptable to both of the parties taking into account their respective perspectives and the options realistically available to each of them at the time of entering into the transaction.
The nub of the issue that will no doubt come before an Australian court is how the statutory instruction (section 815-135) that arm's length conditions must be determined "so as to best achieve consistency" with the OECD Guidelines should be applied.
What are the implications of Cameco in the Australian context?
In light of similarities between paragraphs 247(2)(b) and (d) of the Canadian Act and section 815-130 of the ITAA 1997, the Canadian decision of Cameco may provide useful guidance in the Australian context as to the circumstances in which the Commissioner should make a transfer pricing adjustment by recharacterising the commercial or financial relations between the entities in question.
To the extent Australian Courts construe Subdivision 815-B in a way which is consistent with Cameco approach, it may be that, in order to recharacterise a transaction under section 815-130 of the ITAA 1997, the Commissioner may need to establish that (to quote Cameco) "a taxpayer and non-arm's length non-resident have entered into a transaction or a series of transactions that would not have been entered into between any two (or more) persons dealing at arm's length, under any terms or conditions" [Emphasis added].
If an Australian taxpayer can demonstrate that the disputed transaction:
- can in fact be priced by reference to its actual characteristics; and
- is not a transaction that independent parties dealing wholly independently of one another in comparable circumstances would not have entered into (either on its actual terms, or at all),
reasoning similar to that in Cameco could result in the exceptions in section 815-130 of the ITAA 1997 not being enlivened, such that any transfer pricing adjustment by the Commissioner would be largely confined within the parameters of the transaction or structure actually entered (noting that an Australian Court would not be "straight jacketed" by contrived arrangements).
It is worth noting that this construction does not sit comfortably with the Commissioner's currently expressed views relating to section 815-130 of the ITAA 1997. In Taxation Ruling 2014/6, the Commissioner specifically states that the second exceptional circumstance in the OECD Guidelines, that the actual structure practically impedes the determination of an appropriate transfer price, is not a separate condition under subsection 815-130(3).
In the Commissioner's view, subsection 815-130(3) and (4) will likely be enlivened if the entry into a transaction or arrangement is "commercially irrational such that it would not be entered into by independent parties". The Commissioner goes on to say that this "will always be the case where the taxpayer had options realistically available other than to enter into the actual transaction or arrangement and one or more of these options were more economically attractive … than the arrangement actually adopted."
The Commissioner's current position sets the bar lower than that adopted in Cameco, with not just a focus on the commercial rationality of the disputed transaction, but with a requirement the Australian taxpayer had no other more attractive options. The difficulty with this seemingly extra requirement is that the Commissioner replaces the decision maker's commercial judgement with his or third parties' views (often made with the benefit of hindsight). Company boards often have different appetites for similar risks (e.g. some companies will favour a larger mix of long-term debt than others, even if it is more expensive; some companies will take considerable FX risk, while others are prepared to pay significant premiums to remove that risk).
Whilst it must be acknowledged that the Australian statutory regime differs to the Canadian regime, both place a level of reliance on OECD Guidelines. Construction of our domestic legislation consistently with those Guidelines, in the context of Australia's support for the OECD BEPS project and our accession to the Multilateral Instrument, would seem logical. The ability to request a mutual agreement procedure along with the increasing adoption of binding mandatory arbitration through the Multilateral Instrument may result in alternative dispute resolution procedures with a greater focus on OECD Guidelines over State-based statutory regimes.
The full impact of the approach in Cameco in an Australian context is yet to be seen.
[1] Canada v Cameco Corporation 2020 FCA 112.
