Dr. Amir Pichhadze, Research Assistant at York University (Canada). Formerly, a Judicial Law Clerk at the Tax Court of Canada (TCC), a Tax Law Lecturer at Deakin University Law School (Australia), and a Tax Policy Advisor at the Department of Finance (Canada). He studied at the University of Oxford (MSc in Higher Education), LSE (LLB in Law; LLM in Taxation), University of Michigan Law School (LLM in International Tax and SJD) and the University of Toronto.  He has written several scholarly articles on the present topic, including Pichhadze, Amir (February 2015) ‘Exposing Unaddressed Issues in the OECD’s BEPS Project’ World Tax Journal, 7(1), 99-167; and Pichhadze, Amir (2017) ‘The Role of Contract Interpretation in Transfer Pricing Law: Lessons from Canada’ Canadian Tax Journal, 65(4), 849-92.  For further information, see: Here

Based on recent caselaw in Canada, this article cautions about the risk of failing to correctly construe transactions when conducting transfer pricing analysis, which could result in a finding that an error of law and/or fact has been made.

The need to delineate transactions in transfer pricing

Around the world, domestic transfer pricing laws require that, for the purposes of applying tax law, the terms of controlled cross-border transactions should be similar to those that were (or would have been) agreed to, had the contracting parties been dealing at arm’s length. As explained in the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“TPG”),[1] this requires delineating the conditions and economically relevant circumstances of the transaction(s) which the related parties executed. The delineated controlled transaction can then be compared to a comparable uncontrolled transaction, i.e. one that is similar in conditions and circumstances, but carried out at arm’s length. If need be, based on this comparison, the tax authority could adjust the terms [of the delineated transaction] to bring them in line with those that were agreed to in comparable transactions that took place. Where comparable transactions that took place cannot be identified, the terms [of the delineated transaction] would be brought in line with those in a hypothetical transaction that could presumably be comparable in circumstances, but without the conditions of control (i.e., comparable hypothetical transactions involving parties dealing at arm’s length under otherwise similar circumstances).

An accurate delineation of the controlled transaction requires considering different comparability factors such as the contractual terms agreed to by the parties, the functions performed by each party, the characteristics of the property or service provided, the economic circumstances of the parties and the market in which the parties operate, and the business strategies pursued by the parties.[2]

Having accurately delineated the controlled transaction, if it is found that some of its terms are different from those that were (or would have been) agreed to in a comparable uncontrolled transaction, the law will typically authorize some or all the following consequences. It could authorize adjusting some of the terms in the delineated transaction so that taxation will be based on the same delineated transaction but with the adjusted terms. It may also be found that, under comparable circumstances, unrelated parties would have agreed to a wholly different transaction. To deal with such a scenario, the law may authorize the tax authority to replace the whole delineated transaction (rather than only replacing some terms of the delineated transaction) with another transaction. Taxation would then be based on the terms of the replacement transaction. It may also be determined that parties dealing at arm’s length would not, under comparable circumstances, be expected to agree to any transaction. In such a scenario, the law may authorize completely ignoring the delineated transaction for tax purposes, without any adjustments or replacements.

The need to correctly construe the contractual terms of the controlled transaction being delineated

Generally, taxation is based on the ‘true nature’ of a transaction.[3] Therefore, before applying the relevant tax law, it is necessary to begin by correctly delineating the transaction(s) under assessment.[4] There have been numerous cases, involving the application of different tax laws, in which the ‘true nature’ of the transaction(s) under assessment has been in dispute, which  required the courts to construe the transaction(s) in accordance with the applicable law of contractual interpretation.[5] While courts may consider the litigants’ interpretation of the transaction, it is ultimately the task of the court to apply the correct interpretation.[6] A trial’s court failure to properly construe a transaction could be reviewed on appeal,[7] and may amount to a legal error of law and/or fact.

The risk of failures to construe contracts in transfer pricing disputes

It would seem reasonable to expect that taxpayers [or their professional advisors], tax authorities, as well as judges, would know to correctly construe the contractual terms if and as necessary for the purposes of delineating the actual controlled transaction under assessment. Yet, my review of tax disputes in selected jurisdictions – Canada, the UK, the US, and Australia – revealed that in no transfer pricing dispute to date has this issue of interpretation been pleaded or raised by the courts in transfer pricing disputes. Yet just because the issue may not have been pleaded or raised by the courts, it does not necessarily mean that the task of interpretation was not relevant and should have been pleaded and/or addressed by courts. One such case, which I have identified in my research on transfer pricing, is the tax dispute in Canada that involved the transfer pricing arrangements of GlaxoSmithKline Inc.

Through my study of the litigants’ and courts’ approach to their analysis in this case, I identified the risk that, as evidenced by the parties’ submissions and the courts’ written opinions, all overlooked, either advertently or inadvertently or by mistake, the necessary role of contractual interpretation when carrying out the task of delineating the controlled transaction which was under assessment . The task of contractual interpretation was, however, necessary in order to deal with a contentious issue in this case: what was the ‘true nature’ of the controlled transaction under assessment?

The OECD clarifies the matter in its revised guidelines

In 2017, in line with my own recommendations,[8] the OECD published its revised guidelines which, unlike the previous version of the guidelines, stated at [1.43] that, for the purpose of delineating the transaction between related parties in cross-border transactions, the applicable principles of contract interpretation ought to be considered. Recently, in the book Fundamentals of Transfer Pricing Vol. 1, reference was made to my research when discussing the need to determine the intentions of the parties for the purpose of delineating controlled transactions.[9] The authors pointed out that, as is now required by the OECD’s TPG, the principles of contract interpretation aid in ascertaining the legal implications of contractual obligations.[10]

The risk of an error: an example

Since then, another notable case has processed through the Canadian courts. While this was not a case in which a transfer pricing arrangement was being assessed under Canada’s transfer pricing law, it involved the contractual interpretation of transfer pricing arrangements for the purposes of determining a transfer price amount to be paid as damages for breach of a patent. As will be explained next, this case exemplifies the potential outcomes of failing to correctly construe a transfer pricing arrangement. This ought to alert litigators and courts to the risk of failing to correctly undertake this necessary task of construction where it is necessary to distill the ‘true nature’ of a transfer pricing arrangement.

In Laboratoires Servier, Adir, Oril Industries, Servier Canada v. Apotex,[11] Canada’s Federal Court found that Apotex’s manufacturing and sale of perindopril infringed ADIR’s Canadian patent. Then, in ADIR v Apotex,[12] ADIR, the Plaintiff, was given the option of receiving either a portion of the Defendant’s [Apotex] profits or an amount that reflects the damages suffered from the infringement. ADIR chose to receive a potion of the profits.

As established in Monsanto Canada Inc. v. Schmeiser,[13] the amount of profits that Apotex would have to pay in damages would consist of the difference between its “gross revenues and its current and capital expenses” that was “directly attributable to the infringement.”[14]

Apotex, the Defendant, sold perindopril to Apotex UK, a foreign affiliated company. On the basis of its interpretation of the transfer-pricing agreements between Apotex and Apotex UK, Apotex suggested that, owing to the increased risk that Apotex UK would bring an infringement suit, it charged Apotex UK a “higher price” for the sale of perindopril than the price (the “lower price”) paid by buyers in other countries.[15] By this view, the difference between the “higher” and the “lower” prices represented consideration paid (by Apotex UK) on account of non-patent-infringing indemnity and legal services provided by Apotex to Apotex UK.[16] Accordingly, that amount ought to be disaggregated from the total amount payable to ADIR in respect of the patent infringement.[17]

The trial judge, Gagné J., took “the view that if part of the price paid by Apotex UK and GenRx is proven to have been paid on account of those services, then the revenues should be apportioned or segregated accordingly… The question is therefore, whether or not the defendants have provided sufficient evidence proving that part of the price paid was indeed on account of non-infringing services and indemnity.” ADIR, on the other hand, interpreted the transfer-pricing agreements to mean that the transfer price was a payment only for the perindopril, and thus the whole sum was directly attributable to the patent infringement.[18]

As Justice Gagne explained, while it could take into account the different contractual interpretations of the litigants, the task of construction is ultimately determined by the court. The court therefore had to determine the true nature of the controlled transaction. Specifically with regard to the difference between the “higher” and the “lower” amounts, did the parties intend to have Apotex UK apply the difference solely as consideration paid for the indemnity and legal services or, alternatively, was that amount also consideration for the perindopril?[19] To make this determination, Justice Gagné proceeded to interpret the transfer-pricing agreements by applying the relevant principles of contract interpretation.[20] She concluded that a “proper interpretation of these agreements” did not support the assertion that “the difference between the higher price and the lower price, in the context of the export sales of Apo-perindopril to Apotex UK and GenRx, was paid solely on account of the indemnity provision and related litigation services, and not on account of the sale of the product.” Instead, in her opinion, “segregating or apportioning those revenues would not be equitable in this case.”[21]

As the FCA explained in Salt Canada v. Baker, contractual interpretation can be subject to judicial review on appeal from decisions at the Tax Court as well as in cases from the Federal Court dealing with other areas of the law such as settlement agreements, employment contracts, among others.[22] The FCA follows the SCC’s precedent that contractual interpretation “involves issues of mixed fact and law as it is an exercise in which the principles of contractual interpretation are applied to the words of the written contract, considered in light of the factual matrix.”[23] Hence, based on the SCC’s decision, the FCA stated that “contractual interpretation should be dealt with as a question of mixed fact and law, attracting a deferential standard of review unless an extricable error of law is identified.”[24] The FCA went on to note that “one example of such an extricable legal error,”  identified by the SCC in that case, “was the application of an incorrect principle.”[25]

Apotex appealed Justice Gagné’s decision on the basis that she made an error in her contractual interpretation of the transfer pricing agreements.[26] The FCA found that Justice Gagné committed an extricable error of law in her interpretation of the transfer pricing agreements, though it concluded that Apotex failed to establish that the transfer pricing agreements apportioned revenue as it alleged.[27] Even if interpreted correctly, the appellant had not demonstrated that the revenues received pursuant to the transfer price agreements were intended to be apportioned between revenue received for the drug and revenue received for the indemnity and defence costs the appellant agreed to bear.

Conclusion

It is mandatory to correctly construe contractual arrangements, where it is necessary to do so, in order to then determine their tax consequences. In transfer pricing disputes, and perhaps also in other tax disputes, there is risk that litigants as well as the courts fail to do so, either advertently or inadvertently or by mistake. Perhaps in some cases, such as the GlaxoSmithKline Inc. case, courts have not addressed the issue of construction where it was not raised by the parties in their pleadings. Nevertheless, a court could raise it as an issue that ‘stems’ from the pleaded issues or as a ‘new issue’ that was not pleaded by the parties but is required in order to ensure procedural fairness.[28] Failure to properly construe the actual transaction in question could be subject to judicial review and result in finding that an error was made. It is therefore critical for litigants and courts to be aware of, and take into consideration, the necessary role of contractual interpretation in transfer pricing disputes, as well as in tax disputes generally.

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