Int’l Tax Case Law – Intercompany Fees: No Service Provided

Par Robert Robillard - 3 mai 2016

This blogpost originally appeared on rbrt.ca.

In Edison Transportation, LLC v. The Queen 2016 TCC 80 (available here) heard in the Tax Court of Canada, we learn that :

« [1] The Appellant is a corporation incorporated in Florida on December 22, 2008 that was specifically formed for and operated under an extra‑provincial licence in British Columbia to carry on the business of leasing, managing and operating transit buses with drivers for the 2010 Winter Olympic and Paralympic Games (the “Games”) held in Vancouver in February and March of 2010. The Appellant was denied business expenses totalling $2,238,550 for its 2010 taxation year ($2,100,000 US of the $2,500,00 US claimed) on the basis such expenses were not incurred for the purpose of gaining or producing income pursuant to subsection 18(1)(a) of the Income Tax Act ( the “Act”), or, in the alternative, that if such expenses were so incurred that they were not reasonable pursuant to section 67 of the Act; the consequence of which is the Appellant was reassessed as having net income for such year of approximately $1,923,331 instead of a loss of $891,806.

[2] More specifically, the Minister of National Revenue (the “Minister”) assumed that these specific funds, received as income from Gameday Canada Inc. (“Gameday” ) for providing its services to the Games were transferred to another Florida corporation, iTransit Inc., (“iTransit”) pursuant to an arrangement to effectively pay for shares sold from the previous sole shareholder of the Appellant, one Mr. M. Pouncey (“Pouncey”) to the next sole shareholder, one Mr. R. Hill (“Hill”) as will be more fully canvassed later, or in the alternative, that these funds were not expended for the purpose of gaining or producing income. »

Although not directly based on section 247 ITA (transfer pricing), this is a case that should be of interest to international tax practitioners and businesses involved in cross-border transactions.

The facts show that USD 2,100,000 were paid by CANCO to USCO as « commissions ». The case basically revolves around the factual basis of any service that may have been rendered to justify this amount of « commissions ».

The court explains in details:

« [9] The Appellant entered into two separate agreements with Gameday Canada for a total gross income of about $21,000,000 dated December 29, 2008 for Vanoc’s transit needs and dated November 13, 2009 for busing RCMP security personnel; the latter which Gameday Canada had agreed to provide as a subcontractor to another corporation. Notwithstanding that the Appellant was only incorporated on December 22, 2008 in Florida, the evidence is that Pouncey, Vitrano and one of Vitrano’s staff, Don Jordan, had been negotiating such contract in the Appellant’s name since October, 2008, which was the explanation given by the Appellant’s witnesses as to why the Appellant’s name appeared on a draft contract dated October, 2008, before the Appellant’s incorporation; an explanation that seems credible and within the ambit of normal business practices in my view.

[10] The other relevant contract in the dispute involves a contract between the Appellant and iTransit dated May 4, 2009 (the “iTransit Agreement”) pursuant to which the Appellant purportedly agreed to pay iTransit the sum of $2,500,000; primarily, according to the evidence of Pouncey, to cover iTransit’s substantial costs incurred in providing support services to the Appellant or for its benefit before, during and after the Games and to some extent to compensate it for its assistance in helping it obtain the Gameday contracts. It is this contract and more so the payment required thereunder that forms the basis for the main dispute between the parties and the Minister’s assumptions above referred to. »

The court basically refutes the validity of these agreements:

« [42] Secondly, and more importantly, this Court is not bound by false facts pleaded by the Appellant. In Hammill v The Queen, 2005 FCA 252, 2005 DTC 5397, Noel J.A., in refuting the submission by the appellant’s counsel therein that the Court was bound by the facts as admitted, stated at paragraph 31:

31 In an appeal against an assessment under the Act, the outcome does not belong to the parties. Public funds are involved and the Tax Court is given, in the first instance, the statutory mandate to confirm or vary the assessment based on the facts, proven or admitted. In this respect, while the Court will not generally look behind a formal admission, the parties cannot by agreement dictate the outcome of a tax appeal. The Tax Court is not bound by an admission which is shown, through properly tendered evidence, to be contrary to the facts.

[43] The evidence is clear and not disputed by the Appellant that this Agreement was not prepared until sometime in 2010 and not executed until late in 2010, several months after the completion of the Games and the start of correspondence with the CRA regarding a Regulation 105 (withholding taxes) audit but several months before the Appellant was formally notified by the CRA of the T4 audit to commence against it that led to this matter.

[44] However the Appellant argues that despite any backdating of the Agreement, the parties effectively honoured the terms thereof and so their actions give effect to the late signed Agreement and support its validity. The Appellant also argues that the parties were occupied with the demands of the business and it was not unusual as we have seen to execute documents later than their purported dates so such late preparation and execution does not derogate from the fact their actions carried out the Agreement.

[45] No explanation was given as to why it took so long to prepare and execute an Agreement that was to reflect what was described as a meeting around May 4, 2009 with the Appellant’s lawyers, accountants and Hill to address compensation for the costs iTransit had expended in support of the Appellant’s contractual duties other than an unconvincing argument by counsel that they habitually signed or backdated documents as a matter of course and abided by its terms and so no adverse inference should be made as to such backdating. »

The court also found serious inconsistencies in the content of the purported agreements and the actual facts, including:

« [49] The Appellant argued that a finder’s fee or commission is deductible relying on cases such as Canderel and Canada Permanent Mortgage Corp. earlier discussed and is not required to correlate to the Appellant’s profit or source of income in reliance on former Chief Justice Bowman’s decision in Bush Associates Ltd. v The Queen, 2010 TCC 159, 2010 DTC 1160, at paragraph 34. Even though Bush dealt with the payment of bonuses to individual shareholders and not to finders fees or commissions and so is distinguishable, I do not take issue with the Appellant’s argument that a finder would not be expected to take a reduced finder’s fee or commission simply because through no fault of his, the operator lost money; this in the context of addressing the auditor’s reasons for not finding there was a commission payable since it was not subject to adjustment. Such argument however presumes there was an agreed commission or finder’s fee to begin with, at least a formula, consistent with the facts in Canderel or Canada Permanent Mortgage Corp. I am not swayed by the Appellant’s argument that treatment of finder’s fees or commissions should be equated with the payment of discretionary bonuses to shareholders usually made after the company’s year-end to reward shareholders or officers and directors for past service; however, notwithstanding my disagreement with such analogy, even if I accept payment can be made for past services, there must at least be some agreement as to the quantum or calculation of such fee or commission in advance in the context of business in order to characterize such payments as such. It is in the very nature of these types of payments that they are calculable on some objective basis and not merely discretionary. Frankly, the Appellant seems to be inconsistent on this matter. Pouncey and Robbins testified so as to deny there was any set amount payable for commissions, thus rendering its very concept in doubt, so much so that they took issue with Hubbell’s correspondence to the CRA with respect to characterizing any portion of the alleged fixed $2.5M fee as commissions of $2.1M. Whatever characterization one may give to the fee in question or one may draw from the evidence, what is clear is that the Appellant has not met the onus of demolishing the Minister’s assumption found in paragraph 26( kk) of the Reply:

kk) the Appellant did not incur any expenses with respect to the claimed Purported Commission in the amount of US$2,100,000 (i.e.CDN$2,238,550) in the 2010 taxation year for the purposes of gaining or producing business income;

[50] Aside from the lack of details, I note an inconsistency between agreed upon facts and the terms of the iTransit Agreement. Section IV of the said Agreement deals with compensation and contains the following terms:

… Edison agrees to pay ITransit the sum of Two million five hundred thousand dollars ($2,500,000). During the course of this contract, Edison may from time to time make payments to iTransit….(Emphasis added)

[51] It is clear from the plain wording of the agreement that payments would be made during the “course of this contract”, which would run from May 4, 2009 onwards as its term. Notwithstanding this, the parties agreed in paragraph 1.67 of the Partial Statement of Agreed Facts and Issue that:

…Edison recorded, for accounting purposes, the $US 2.5 million as an accrued account payable, payable to iTransit on the following dates:

30 January 2009 $US 250,000

as well as three other payments of $US 500,000, $1,125,000 and $625,000 on November 30, 2009, January 15, 2010 and April 30, 2010.

[52] It is clear that both the invoice of January 30, 2009 is prior to the date of the Agreement which makes no reference to existing credits on account, and that all the payments were allegedly invoiced as of April 30, 2010, about 6 months or so before the Agreement was signed, yet no mention of such being made therein, notwithstanding the fact the parties had clear knowledge of the such facts.

[53] There was evidence of many transfers of funds from the Canadian and American bank accounts of the Appellant to iTransit but there is no correlation in amounts between the above referred to invoices and these payments that might assist in linking the two. When one considers Hill’s testimony that he expressed concerns funds being transferred to iTransit might affect the ability of the Appellant to conduct its contracted obligations, it seems clear there was no connection between these payments and invoices. If these were expected and agreed upon payments, Hill would have had no justification for concern. »

The reasonableness of the expenditures is also demolished by the court :

« [70] The simple fact is the Respondent has assumed that no more than $400,000 was paid to iTransit for the support services it provided and the onus is on the Appellant to justify a higher amount and that any such amounts were expended for the purpose of gaining or producing income and if so, that they were reasonable. The Appellant has not remotely come close to demolishing the Minister’s assumptions. The Appellant has not provided any credible advice that it received support services greater than $400,000, let alone any specific amount. The Appellant has not tendered into evidence receipts, complete signed financial statements or any other reasonable evidence detailing what services were received from iTransit and at what cost that would form the basis of the reimbursement Pouncey alluded to earlier. All we have is an agreement dated May 4, 2009, prepared and signed long after that date, more than a year, that contains a total $2.5M fee, at a time when the Appellant and iTransit would be in a position to know exact amounts of the cost of any services provided. Recalling the evidence of Pouncey himself who indicated that the fee reflected primarily the cost of the services iTransit supplied to the Appellant, and was arrived at after a meeting with the company lawyer and accountant as well as Hill who denied being present, one would expect some corroborating evidence in support of that. As earlier mentioned, in the circumstances, I gave this agreement little weight. »

The court concludes:

« [74] Regardless of how competent and skillful counsel for the Appellant may be in argument, there must be foundational evidence to support the facts he presumes to take as true. I do not find the Appellant has met the onus of demolishing the Minister’s assumptions that no more than $400,000 was paid to iTransit for any support services provided. »

This case is a harsh reminder that any cross-border transaction should be planned, implemented, and documented carefully…

The library on Transfer Pricing in Canada is available here.

Robert Robillard, Ph.D., CPA, CGA, Adm.A., MBA, M.Sc. Econ., M.A.P.
Senior Partner, RBRT Inc.
514-742-8086; robertrobillard « at » rbrt.ca
www.rbrt.ca

The convergence of RBRT’s tax, accounting and economics expertise makes a difference. The information in this blog post is general information only. Data and information come from sources believed to be reliable but complete accuracy cannot be guaranteed. RBRT Inc. or the author are not responsible or liable for any error, omission or inaccuracy in such information. The opinions expressed in this blogpost are those of the author. Readers should seek advice and counsel from RBRT Inc. as required.