Tax Haiku of the week:
Caution is advised
Because transfer pricing is
Not fun in the sun
Marzen Artistic Aluminum Ltd. v The Queen, 2014 TCC 194
Link to Federal Court Document
by Jonathan Garbutt, Barrister & Solicitor, and Raminder Pandher, Student-at-law
In Marzen Artistic Aluminum Ltd. v The Queen, the taxpayer, Marzen, bought services from its Barbados subsidiary, and deducted a combined $7,311,120 against its Canadian income tax in 2000 and 2001. The Tax Court of Canada (“TCC”) disallowed these deductions and levied a transfer pricing penalty of $502,519 for the 2001 taxation year under subsection 247(3) of the Income Tax Act (the “Act”).
Marzen was a Canadian corporation carrying on the business of manufacturing and selling window products. Starline Windows Inc. (“SWI”) was its U.S. subsidiary. SWI had limited success entering the U.S. marketplace in Washington State. As a result, Marzen’s legal counsel suggested that it contact David Csumrik to discuss a new sales strategy. Csumrik suggested shifting SWI’s focus to the high-rise market in southern California.
In 1999, under the guidance of Csumrik, Marzen began implementing a series of arrangements and agreements, which the Court referred to as the “Barbados Structure”. Under this structure, Marzen entered into a “Marketing and Sales Services Agreement” (“MSSA”) with Starline International Inc. (“SII”), a Barbados-based corporation wholly owned by Marzen, to provide marketing and other sales-related services. Marzen, SII and SWI were deemed under the Act not to deal at arm’s length.
Total fees paid by Marzen to SII under the MSAA in 2000 and 2001 were $4,168,551 and $7,837,082, respectively. In both of these years, the marketing fees paid to SII were the largest expense on Marzen’s income statement. SII paid nominal income tax in Barbados under this scheme. SII then declared dividends to Marzen, which were then deducted from Marzen’s taxable income pursuant to section 113 of the Act on the basis that they had been paid out of SII’s exempt surplus.
The Canada Revenue Agency (“CRA”) reassessed Marzen under section 247 of the Act. The CRA disallowed a portion of the deduction, and imposed a penalty of $502,519.
Analysis of the case
The TCC was not convinced that SII could provide any tangible services to Marzen by itself, calling it “an empty shell with no personnel, no assets and no intangibles or intellectual property.”Instead, the TCC focused on the role played by Csumrik, specifically the services he provided and the extent that his efforts could be attributed to the services SII was obliged to provide to Marzen under the MSSA. The TCC concluded that Csumrik did very little other than provide managing director services. As a result, the TCC held that the arrangement between Marzen and SII did not satisfy the arm’s-length principle. The terms and conditions of the arrangement conferred “attractive advantages” which would not be available to an arm’s length party.
The TCC held that an arm’s length’s party would have paid an amount to SII that exceeded the fees paid by SII to SWI, but only in the amount of $32,500 in each of 2000 and 2001. Thus, the majority of the fees paid by Marzen to SII were denied and added back into Marzen’s income. The TCC also found that the transfer pricing penalty was applicable because Marzen was “deemed not to have made reasonable efforts to determine and use arm’s length transfer prices” in 2001. The 2000 adjustment did not meet the $5 million threshold for imposing a penalty under subparagraph 247(3)(b)(ii) of the Act. Costs were awarded to the CRA.
A key factor that the TCC focused on was the annual fee Csumrik charged for his services as a managing director of SII; only $2,500 per year. His company received another $30k for providing corporate services, but his personal compensation was very limited. Marzen’s position was that his contacts (although that position blew up in discoveries when Csumrik admitted he did not have any relevant contacts…) and business acumen with regard to the U.S. market was responsible for SWI’’s increased sales. However, as Justice Sheridan rightly questioned, if he had actually been providing such enormous benefits to Marzen (i.e., increasing SWI’s sales in the U.S. by millions), why wouldn’t he have demanded more than the managing director’s annual stipend?
The fundamental problem with many transfer pricing based structures is that the corporate group must actually transfer risks and functions to the entity in the lower tax jurisdictions. InMarzen, the Barbados subsidiary did not take on any risk nor did it have much in the way of actual functions, but they still received all of the profits. That makes no sense. As we often re-iterate, TCC judges have a very good nose for B.S., and you can’t fool them, even with a snappy catch-phrase such as “the proof is in the pudding.” There still has to be some logic in said pudding or there is no proof.
So, this case does not mean that Barbados structures do not work, rather it stands for the proposition that you have to make Barbados structures work by having them actually do some work. The TCC has respected such structures when the risks and functions are in fact where they are supposed to be. If it is done properly, as in for example the Alberta Printed Circuits case , the taxpayer will prevail (for the most part), and it can be the CRA that ends up being taken to the woodshed by the TCC for using weak transfer pricing methodologies.
Moreover, it would not have been difficult for Marzen to have made proper arrangements so as to achieve similar results in a compliant manner. For example, SII could have agreed to bulk pre-purchase Marzen’s products at the factory gate (FOB) at an arm’s length wholesale price (as determined by a proper transfer pricing report). SII would have then sold Marzen’s products in the US market at market prices (thereby taking on the cost/risk of storage and not being able to unload excess stock), then the structure might have had at least some “air of reality”. In this situation, SII would also incur risks associated with transporting the goods, dealing with contract and credit arrangements in the U.S.(including the liability for any product defects etc.), and accepting the risk of non-payment from US customers. It also would have been possible for SII to take the US sales force, offices, inventories etc. onto its books. SII would have taken on all the risks associated with the US operations in a more realistic manner, and therefore it would make a lot more sense for SII to also then to have received all of the profits. As a result, although no plan is bulletproof, it would have been much harder for the CRA to impugn the credibility of both Csumrik and the management of Marzen as to the actual nature of the structure.
However, instead of spending some money and taking the time to do it properly, Marzen’s a “quick and dirty” approach to transfer pricing made no sense, and they lost. Their mistake was to relying on their advisors’ word that the structure was “OK”, without getting proper transfer pricing reports from economists on what risks and functions could be realistically transferred to the Barbados, and what those risks and functions were actually worth.
 2014 TCC 194 [Marzen].
 Income Tax Act, RSC 1985, c 1 (5th Supp).
 Marzin, supra note 1 at para 20.
 Ibid at para 136.
 Ibid at para 157.
 Ibid at para 172.
 Ibid at para 172.
 Ibid at para 216.
 Ibid at para 231.
 Ibid at para 218.
 Ibid at para 211.
 Ibid at para 171.
 Alberta Printed Circuits Ltd v The Queen, 2011 TCC 232 [Alberta Printed Circuits].