Transfer Pricing Update – Imputing Transactions & the Appropriateness of Guarantee Fees Tax Executives Institute (Calgary) – May 30, 2017 Julie D’Avignon

707917 MAY 30, 2017 STIKEMAN ELLIOTT LLP

Today’s Topics Appeals from Transfer Pricing Reassessments: 1. Suncor Energy Inc. (As Successor to Petro-Canada) v R 2. Burlington Resources Finance Company v R 3. Conoco Funding Company v R

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STIKEMAN ELLIOTT LLP 1 Suncor Energy Inc. (As Successor To Petro-Canada) v R Notice of Appeal dated November 21, 2014; Reply dated April 13, 2015; and Answer dated July 10, 2015

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Suncor Energy Inc. (As Successor To Petro-Canada) v R

Facts Corporate Structure (Simplified)

• Appeal by Suncor from a notice of 3rd Petro-Canada reassessment of its predecessor, Parties Hedges on Brent Petro-Canada for the 2007 tax year crude oil

• The Minister’s transfer pricing 3908968 Canada adjustment based on s. 247(2)(a) Inc. and (c) of the Income Tax Act Canada (Canada) (“ ITA ”) increased Petro- Canada’s income by $2 billion UK

• In 2004 PCUK, a UK-based Holdings UK subsidiary of Petro-Canada, acquired certain assets in the North Sea 3rd PCUK Parties Sale of oil from • Around that time, Petro-Canada North Sea asset entered into forward contracts for the sale of 28,000 bbl/d of Brent North Sea Oil crude oil at $~25/bbl for the period Assets July 1, 2007 – December 31, 2010

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STIKEMAN ELLIOTT LLP 2 Suncor Energy Inc. (As Successor To Petro-Canada) v R

Facts (Cont’d)

• The North Sea oil assets started Price of Brent Crude Oil $US/bbl producing in 2007. Expected 140 production of 60,000 bbl/d Board authorizes 120 close out of • The first cash settlements on the hedges

forward contracts became due in 100 First cash July 2007. Initial cash settlement settlement payments of USD $287 million due 80

• $US/bbl The price of crude had risen 60 Petro-Canada dramatically since 2004, Petro- enters hedges Canada entered into swaps to close 40 out the forward contracts with a settlement payment of USD $1.7 billion 20

0 • Petro-Canada deducted these settlement payments in calculating Jul-2002 Jul-2007 Jan-2000 Jan-2005 Jun-2000 Jun-2005 Oct-2003 Apr-2001 Apr-2006 Sep-2001 Feb-2002 Sep-2006 Feb-2007 Dec-2002 Dec-2007 Aug-2004 Nov-2000 Nov-2005 Mar-2004 its income May-2003 May-2008

Source: US Energy Information Administration

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Suncor Energy Inc. (As Successor To Petro-Canada) v R

Minister’s Grounds for Reassessment

• The Minister imputed a $2 billion reimbursement from PCUK to Petro-Canada for the hedging losses

• The Minister made certain findings of fact: – The hedges were part of a strategy to allow Petro-Canada to increase its bid for the North Sea oil assets – Petro-Canada was the only company authorized to undertake forward contracts and the only company that could supply the credit to undertake such contracts

• The Minister’s view was that, for the purposes of applying s. 247(2), the “series of transactions” encompassed: – The acquisition of the North Sea oil assets – Entering into the forward contracts – Closing out the forward contracts

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STIKEMAN ELLIOTT LLP 3 Suncor Energy Inc. (As Successor To Petro-Canada) v R

Minister’s Grounds for Reassessment (cont’d)

• Petro-Canada and PCUK were participants in an imputed transaction, whereby Petro- Canada entered into the hedges for the benefit of its non-resident subsidiary

• Minister considered Petro-Canada and PCUK to have priced such imputed transactions at $0 as no reimbursement of Petro-Canada by PCUK

• If the parties had been dealing at arm’s length, Petro-Canada would have allocated hedging gains to PCUK and PCUK would have reimbursed Petro-Canada for hedging losses

• Minister applied a penalty for Petro-Canada’s failure to adequately prepare contemporaneous documentation

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Suncor Energy Inc. (As Successor To Petro-Canada) v R

Notice of Appeal

• Issues: – Whether the Minister erred by applying s. 247(2)(a) and (c) to impute a reimbursement by PCUK to Petro-Canada?

– Whether, even if s. 247(2)(a) and (c) apply, the Minister erred in assessing Petro-Canada on the basis that the transfer price between Petro-Canada and PCUK was inconsistent with the arm’s length standard?

– Whether the Minister erred by applying s. 247(3) and (4) to impose a penalty for the alleged failure to adequately prepare contemporaneous documentation?

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STIKEMAN ELLIOTT LLP 4 Suncor Energy Inc. (As Successor To Petro-Canada) v R

Notice of Appeal (Cont’d) • Reasons: – S. 247(2)(a) and (c) does not apply: • Petro-Canada participated in two transactions: (1) entering into the forward contracts on its own behalf; and (2) settling those contracts • PCUK participated in two transactions: (1) the North Sea assets acquisition; and (2) earning revenue from the production and sale of crude oil from those assets with other arm’s length parties • Each of the transactions were made with arm’s length parties • The Minister’s application of s. 247(2)(a) and (c) results in an arbitrary application of the provision requiring taxpayers to self-report on imputed transactions that do not actually occur – Even if s. 247(2)(a) and (c) apply, the transfer price imputed by the Minister between Petro-Canada and PCUK was inconsistent with the arm’s length standard: • The adjustment makes PCUK liable for the obligations of Petro-Canada, which is inconsistent with the legal obligations of the parties

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Suncor Energy Inc. (As Successor To Petro-Canada) v R

Notice of Appeal (Cont’d) • Reasons: • An arm’s length party would not make a $2 billion voluntary payment without a legal obligation • The $2 billion reimbursement would not have been agreed to by arm’s length parties. • Arm’s length price would be nil as PCUK had no entitlements or obligations under the forward contracts – There was no failure to adequately prepare contemporaneous documentation: • There was no transaction within the meaning of s. 247 to be documented and therefore no failure to document a transaction according to s. 247(3) and (4) • Asserting that a taxpayer should document notional transactions which the Minister may impute is inconsistent with the textual, contextual and purposive interpretation of s. 247(3) and (4) • Subsections (3) and (4) require reasonable efforts. Petro-Canada exercised reasonable diligence in the circumstances in documenting the transactions that actually occurred • Petro-Canada provided contemporaneous documentation with respect to each of the transactions in the series of transactions

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Minister’s Reply • Issues: – Whether s. 247(2)(a) and (c) apply to adjust Petro-Canada’s income? – Whether Petro-Canada is liable to a penalty pursuant to s. 247(3)? • Reasons: – The Minister correctly applied s. 247(2)(a) and (c) to adjust Petro-Canada’s income: • Petro-Canada engaged in the forward contracts to hedge the price risk of its indirect subsidiary, PCUK, to guarantee a certain level of return for the North Sea asset acquisition • When PCUK acquired the North Sea assets, it also acquired the crude oil price risk. An arm’s length party would have reimbursed Petro-Canada for hedging losses – Petro-Canada is liable to a penalty pursuant to s. 247(3): • Petro-Canada did not make reasonable efforts to determine arm’s length transfer price with PCUK • Petro-Canada did not make or obtain adequate documentation

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Suncor Energy Inc. (As Successor To Petro-Canada) v R

Comments

• According to a Suncor press release dated December 5, 2016, Suncor successfully resolved the dispute with the CRA, resulting in no additional taxes, interest or penalties

• The CRA position takes a broad view of the transfer pricing provisions of the ITA: – CRA imputed a transaction in absence of any legal obligation, legal entitlement or contractual relationship – Purports to expand the onerous requirements of the transfer pricing to notional transactions

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STIKEMAN ELLIOTT LLP 6 Burlington Resources Finance Company v R Notice of Appeal dated June 26, 2012; and Reply dated October 9, 2012

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Burlington Resources Finance Company v R

Facts

• Appeal by BRFC from a notice of reassessment for the 2002 - 2005 Corporate Structure taxation years (Simplified)

Burlington • BRFC was a Nova Scotia unlimited Resources Inc. 0.5% guarantee liability company (“ ULC ”) that Guarantee of BRFC’s debt (“BRI”) fee to parent borrowed funds with its parent’s US guarantee and on-loaned those funds to related entities Canada Burlington • In exchange for the guarantee, Burlington 3rd Resources Finance BRFC paid its parent a 0.5% fee and Resources Parties Company (“BRFC”) deducted that fee in calculating its Loans On-loaned Group income funds to related entities at a spread • BRI sought advice from investment banks in determining an appropriate guarantee fee and agreed to the 0.5% fee with BRFC based on that advice

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Minister’s Grounds for Reassessment • The Minister reduced the guarantee fees to nil and imposed transfer pricing penalties pursuant to s. 247(3)

• The Minister made certain findings of fact: – BRFC was established with minimal capital, no employees, no operations, no collateral and no cash flow – BRFC could not borrow funds without its parent’s guarantee – No bona fide purpose for this structure and the guarantee, other than to obtain a tax deduction for BRFC – An arm’s length party would require a fee at such an excessive rate that BRFC would not be able to on-loan its funds at a competitive rate – The terms and conditions of the transaction differed from those that would have been made between person’s dealing at arm’s length – Arm’s length parties would not have required that there be any fee in respect of BRI’s guarantees. Consideration would have been nil if the parties were dealing at arm’s length

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Burlington Resources Finance Company v R

Notice of Appeal • Issues: – Whether the Minister properly applied s. 247(2)(a) and (c) to eliminate the deduction of the guarantee fee by BRFC? • i.e. Whether the guarantee fee paid by BRFC to BRI exceeded the arm’s length amount? – Whether the Minister properly applied s. 247(3) and 247(4)(a)(iv) and (v) in assessing transfer pricing penalties? • Reasons: – The guarantee fee did not exceed the arm’s length amount: • Based on the Minister’s findings of fact: (1) BRI’s credit rating was BBB+; (2) BRFC’s unguaranteed credit rating was BBB-; (3) BRFC could not carry out its business without the guarantee from BRI; (4) the guarantees were imperative for an arm’s length lender to BRFC – BRFC made reasonable efforts to determine arm’s length transfer prices • Relied upon external advice

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Minister’s Reply • Issues: – Whether the Minister properly reassessed BRFC for the taxation years 2002 – 2005? • Whether the charges (i.e . guarantee fees) were incurred by BRFC for the purpose of earning or producing income from its business? • Whether the terms and conditions of the charges differed from those that would have been made between persons dealing at arm’s length? • Whether the series of transactions in respect of the charges would not have been entered into between persons dealing at arm’s length and can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit? • Reasons: – The charges were not incurred for the purpose of earning or producing income from BRFC’s business under ss. 18(1)(a) and 20(1)(e.1): • The charges were incurred for the purpose of obtaining a tax benefit • The charges were redundant given BRFC’s status as a ULC

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Burlington Resources Finance Company v R

Minister’s Reply (Cont’d) • Reasons: – The terms and conditions of the charges differed from those that would have been made between arm’s length parties: • The consideration would have been nil had the parties been dealing at arm’s length

– The transaction would not have been entered into between parties dealing at arm’s length and can reasonably be considered to have been entered into primarily to obtain a tax benefit, as no arm’s length party would: • guarantee BRFC’s debt at any price given the lack of capitalization and level of risk • guarantee BRFC’s debt without covenants restricting the unilateral ability of the parent to dictate the terms of the debt and repayment • agree to pay the guarantee fee to BRI when BRI could dictate the capitalization, terms of the debt and repayments of the debt of BRFC • be paid by BRFC to further guarantee its debts when the ULC status already provided an economic incentive for BRI to ensure that default would not occur

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Comments

• In procedural motions, the Court allowed the appellant’s motion to strike the Crown’s Amended Reply but allowed the Crown to file a further Amended Reply – The Court held that the issue to be decided was whether the guarantee fee exceeded the arm’s length amount and not the existence of the guarantee fees themselves • In General Electric Capital Canada Inc v R , 2010 FCA 344, the Court held that a 1% guarantee fee paid to the US parent was appropriate as the third party borrowing costs of GE Capital would have been at least 1% higher without the guarantee – However, this case is distinguished based on BRFC’s status as a Nova Scotia ULC. The Crown argues that an arm’s length party would not pay a guarantee fee given that the parent is already liable for BRFC’s debts – In GE Capital , the taxpayer was a limited liability company

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Conoco Funding Company v R Notice of Appeal dated July 9, 2013; Reply dated November 8, 2013; and Answer dated December 20, 2013

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STIKEMAN ELLIOTT LLP 10 Conoco Funding Company v R

Corporate Structure – Pre Internal Facts Reorganization (Simplified)

• Appeal by CFC from a notice of reassessment for the 2002 - 2005 Guarantee Conoco Inc. taxation years debt of CFC 0.5% guarantee fee to Parent

• CFC was a Nova Scotia ULC that Conoco Petroleum borrowed funds with its parent’s Operations Inc. (“CPOI”) guarantee to finance the US acquisition of Gulf Canada

• In exchange for the guarantee, CFC paid its parent a 0.5% fee and deducted that fee in ConocoPhillips calculating its income Conoco Funding Canada Ltd. 3rd Company (“CFC”) On-loaned (“CPCL”) Parties $4.5 Billion funds to credit facility finance Gulf acquisition Gulf Canada Resources Limited (“Gulf”)

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Conoco Funding Company v R

Minister’s Grounds for Reassessment • Similar to the Burlington case, the Minister reduced the guarantee fees to nil and imposed transfer pricing penalties pursuant to s. 247(3) • In addition to the grounds of reassessment mentioned in the Burlington case, the Minister made certain findings of fact: – CPOI and CPCL entered into subscription agreements to enable CPCL to repay its financing obligations to CFC. The subscription agreements provided CFC with a form of support making the payment of guarantee fees to the parent redundant – If the yield approach applies, there was no economic incentive for CFC to enter into the guarantee fee transaction, as the costs exceeded the benefits of the guarantee – CFC did not make reasonable efforts to determine arm’s length transfer prices as CFC did not consider among other things: • the extent a guarantee fee would be applicable if an implicit guarantee already existed • whether the guarantee provided a benefit • whether the appellant’s stand-alone credit rating was sufficient along with the implicit support anticipated by the open market from the parent

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STIKEMAN ELLIOTT LLP 11 Conoco Funding Company v R

Notice of Appeal • Issues: – Whether the Minister properly applied s. 247(2)(a) and (c) in determining the income of CFC? • i.e. Whether the guarantee fee paid by CFC to the parent exceeded the arm’s length amount?

– Whether the Minister properly applied s. 247(3) and 247(4)(a)(iv) and (v) in assessing transfer pricing penalties?

• Reasons: – The guarantee fee did not exceed the arm’s length amount

– CFC made reasonable efforts to determine arm’s length transfer prices and used those prices

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Conoco Funding Company v R

Minister’s Reply • Issues: – Whether the guarantee fees were incurred by CFC for the purpose of earning or producing income from its business? – Whether the terms and conditions of the guarantee fees differed from those that would have been made between persons dealing at arm’s length? – Whether the guarantees would have been entered into between persons dealing at arm’s length and can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit?

• Reasons: – The guarantees were not incurred for the purpose of earning or producing income from CFC’s business under ss. 18(1)(a) and 20(1)(e.1): • The guarantee fees were incurred for the purpose of obtaining a tax benefit • The guarantee fees were redundant given CFC’s status as a ULC and the subscription agreements

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STIKEMAN ELLIOTT LLP 12 Conoco Funding Company v R

Minister’s Reply (Cont’d) • Reasons: – The terms and conditions of the guarantee fees differed from those that would have been made between arm’s length parties: • The consideration would have been nil had the parties been dealing at arm’s length

– The transaction would not have been entered into between parties dealing at arm’s length and can reasonably be considered to have been entered into primarily to obtain a tax benefit, as no arm’s length party would: • guarantee CFC’s debt at any price given the lack of capitalization and level of risk of CFC • guarantee CFC’s debt without covenants restricting the unilateral ability of the parent to dictate the terms of the debt and repayment • agree to pay the guarantee fee to the parent when the parent could dictate the capitalization, terms of the debt and repayments of the debt of CFC • be paid by CFC to further guarantee its debts when the ULC status and subscription agreements already provided an economic incentive for the parent to ensure no default

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Conoco Funding Company v R

Comments • This case presents largely the same issues as Burlington Resources Finance Company and as such the cases are now being considered together

• The Crown no longer disputes the existence of the guarantee fees themselves, but rather that the fees exceeded the arm’s length amount or alternatively that arm’s length parties would not have entered into the transaction

• The redundancy argument is based upon the existence of the subscription agreements in addition to CFC’s status as a ULC

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STIKEMAN ELLIOTT LLP 13 Questions

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Contact us Julie D’Avignon, Partner [email protected]

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