Marzen Artistic Aluminum Ltd. v. The Queen
(June 10, 2014 – 2014 TCC 194) was a transfer-pricing case involving the disallowance of more than $7,000,000 in fees paid in 2000 and 2001 as well as the imposition of a penalty in excess of $500,000 for the 2001 taxation year.
 These appeals arise out of a transfer pricing adjustment made by the Minister of National Revenue (the “Minister”) under paragraphs 247(2)(a) and (c) of the Income Tax Act
(the “Act”) in respect of fees paid by the Appellant to Starline International Inc. (“SII”), a Barbados-based corporation wholly owned by the Appellant. In computing its income for 2000 and 2001, the Appellant deducted the fees paid to SII of CAD$4,168,551 and CAD$7,837,082, respectively.
 In 2000 and 2001, SII paid to Starline Windows Inc. (“SWI”), another corporation in the Appellant’s group of companies, a total of US$1,383,723 and US$1,811,992, respectively, for the secondment of its employees to perform certain services for SII.
 In 2000 and 2001, SII declared dividends of CAD$2,011,500 and CAD$5,299,620, respectively. The Appellant included these amounts in its income for Canadian tax purposes in the 2000, 2001 and 2002 taxation years. The dividends were then deducted from the Appellant’s taxable income pursuant to section 113 of the Act on the basis that they had been paid out of SII’s exempt surplus.
 In reassessing the Appellant’s 2000 and 2001 taxation years, the Minister disallowed the deduction of any amounts in excess of the fees SII paid to SWI:
Paid by the Appellant to SII $4,168,551 $7,837,082
Paid by SII to SWI ($2,058,049) ($2,811,892)
Difference $2,110,502 $5,025,190
 A transfer pricing penalty of CAD$502,519 was levied under subsection 247(3) of the Act for the 2001 taxation year only.
The appellant was a Canadian corporation carrying on the business of manufacturing and selling window products. SI was its American subsidiary:
 At all relevant times, the Appellant was engaged in the design, manufacture and sales of aluminium and vinyl window products (“Window Products”) in Langley, British Columbia. The Appellant’s sole director was Mr. Ron Martini. Mr. Martini and his family controlled directly or indirectly the Appellant, SII and SWI. Thus, the Appellant, SII and SWI are deemed under the Act not to deal at arm’s length.
 SWI was located in Washington State. SWI was a tax resident of the United States (“US”) where it filed tax returns for the taxation years 1998 to 2001. Mr. Rick Stark became the general manager of SWI in April 1998.
 SII, a tax resident of Barbados, was incorporated in Barbados by Mr. David Csumrik, also a resident of Barbados, on September 29, 1998. Mr. Csumrik acted as the company’s initial director and on February 11, 1999 became its managing director. Two other directors were also appointed at that time, Mr. Stark and Mr. Terry Vipond, Mr. Martini’s son-in-law.
 Mr. Csumrik was also the principal of Longview. Neither Mr. Csumrik nor Longview was related to the Appellant, SII or SWI for the purposes of the Act.
SI had limited success in the United Stated. The appellant’s counsel suggested that it contact Mr. Csumrik to discuss new American sales strategies:
 In late summer 1998, Mr. Martini and Mr. Fabian met with Mr. Csumrik in Vancouver. Mr. Csumrik recounted his successful business record and experience in management and negotiation in Canada and the US. For their part, Mr. Martini and Mr. Fabian explained the nature of the Appellant’s business and failure to penetrate the Washington State residential window market. Over the next few weeks, they gave Mr. Csumrik what he described as a “very condensed course” on the making of windows, including a visit to the Appellant’s manufacturing plant. Mr. Csumrik also met with Mr. Stark to learn about SWI’s activities in Washington State.
 Shortly after meeting Mr. Martini and Mr. Fabian, Mr. Csumrik incorporated SII in Barbados on September 29, 1998 with Mr. Csumrik acting as its first director. Neither he nor Mr. Martini was concerned about the possible loss of the approximately $2,000 in incorporation costs should their discussions not bear fruit. Mr. Csumrik said the company could always be used for some other client looking to incorporate in Barbados.
 Discussions continued between Mr. Martini and Mr. Csumrik and it was understood that Mr. Csumrik expected to be compensated for whatever assistance he might ultimately provide. By the end of 1998, Mr. Csumrik had concluded that the Appellant was focussed on the wrong market. He advised Mr. Martini and Mr. Fabian to shift the Appellant’s efforts from Washington State’s residential market to the burgeoning high-rise market in southern California, with a view to targeting western Canadian developers in the area. Mr. Csumrik admitted that he himself had no contacts with such developers and could not recall how he had come to know about their projects in southern California:
The upshot of these discussions was that SII was incorporated to act as the appellant’s sales agent with respect to its American operations:
 During his examination-in-chief, Mr. Martini summarized the operation of the new marketing structure as follows:
The new marketing structure was Mr. Csumrik, the architect of the marketing system, seconded the people that work at [SWI]. [SWI] would sell the product in the U.S. and they would buy from [the Appellant], and when [SWI] received the money from the customer, the same amount would go right through [the Appellant], and then [the Appellant] would pay a 25 percent fee to [SII] for the sales costs.
 Although having described Mr. Csumrik as the “architect” of the new structure, Mr. Martini later admitted that he had no personal knowledge of what Mr. Csumrik actually did; he relied on reports from Mr. Fabian and Mr. Stark. Mr. Stark, SWI’s general manager, was not called as a witness at the hearing.
After an extensive review of the operations of SII and the role of Mr. Csumrik the court essentially concluded that he did very little other than provide somewhat perfunctory managing director services:
 All in all, I am not persuaded by the Appellant’s argument regarding the extent to Mr. Csumrik’s involvement in the performance of functions on behalf of SII. The most that can be said, given the Respondent’s concessions in respect of the admissions on discovery, is that in fulfilling his duties as managing director under the arrangement between SII and Longview, Mr. Csumrik also reviewed some sales records and provided some strategic advice and suggestions to SWI on behalf of SII.
The court rejected the appellant’s “proof is in the pudding” argument, i.e., that the success of SWI was due to the marketing efforts of SII:
 Notwithstanding counsel for the Appellant’s incredulous reaction to the Primary Auditor’s testimony, Mr. Csumrik had already made much the same point in response to counsel’s questions during his examination-in-chief. When Mr. Csumrik was asked about the sales ultimately achieved by the Appellant in the southern California market, he described the results as “outstanding” but volunteered the following reason for that success:
And just to close off, Mr. Csumrik, can you describe the overall results that were achieved under the new marketing structure that was implemented?
I’d say over a relatively short term being 2000 to 2005 or ‘7 or whatever it was, that they were outstanding results. You know, then the real estate market as — I would suggest to you that the real estate market was growing, reminded me of — somewhat of the software market when I was in that. You didn’t have to be good, you just had to be there. I mean there were — things were going. So we gained market share. I don’t know if we gained it at the expense of others or if we just gained it because the market was growing in San Diego, Southern California generally in those days, and it was good. It was a fun ride.[Emphasis added.]
 Thus, it is clear from the Appellant’s own evidence that the increase in sales might have been just good timing. While I agree with counsel for the Appellant that the financial results achieved under the Barbados Structure are relevant to the arm’s length transfer pricing analysis, they do not, in themselves, justify the fees paid under the MSSA and the MSSA Bonus Payment Agreement. Another weakness of the “proof is in the pudding” argument is that it overlooks other aspects of the financial flow in 2000 and 2001; for example, that under the Barbados Structure the fees paid to SII accounted for the Appellant’s largest expense, by far; meanwhile, at the same time the Appellant was reporting losses from its operations, SII’s profits were generating healthy dividends for the Appellant.
As a result the court concluded that the fees paid to SII in 2000 and 2001 were not what would have been agreed upon by parties dealing at arm’s length.
After a comprehensive review of the expert evidence and the arguments the court concluded that the effective value of the services provided by SII did not exceed the annual fee Mr. Csumrik’s company, Longview, charged for his services as a managing director of SII, i.e., US$32,500:
 I am persuaded by the Respondent’s argument that the arrangement between SII and Mr. Csumrik/Longview serves as a reliable internal CUP. It accords with OECD Guidelines 1995 in that it treats SWI and SII as separate entities and respects the legal relationships created under the Barbados Structure. Further, it recognizes SII for what it was, “a flow-through entity or facilitator that makes the services of others available to the Appellant”. I am also satisfied that a reasonable business person would not have paid SII more than the price Mr. Csumrik attached to his own services through Longview. It is an agreed fact that the value of Mr. Csumrik/Longview services was US$32,500 in each of 2000 and 2001.
 Thus, the appeals of the 2000 and 2001 taxation years are allowed, in part, and the reassessments are referred back to the Minister for reconsideration and reassessment on the basis 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 US$32,500 in each of 2000 and 2001.
The court sustained the imposition of a penalty:
 In the event that that proves not to be the case, it is necessary to consider the second aspect of the penalty provision; under clause B of subparagraph 247(3)(a)(ii) and clause B of subparagraph 247(3)(a)(iii), no penalty will apply to a transfer pricing adjustment that relates to a transaction where the taxpayer has made “reasonable efforts” to determine and use arm’s length transfer prices for the purposes of the Act.
 However, these provisions must be read in conjunction with the deeming provisions contained in subsection 247(4). Subsection 247(4) requires the taxpayer to make or obtain records or documents supporting the transfer price in issue by the date that the taxpayer’s return for the year is due and permits the Minister to request such documentation from the taxpayer. If the taxpayer fails to provide such information within 90 days of the Minister’s request, subsection 247(4) deems the taxpayer not to have made “reasonable efforts” to determine and use arm’s length allocations in respect of a transaction.
 According to the Respondent’s argument, the only document that even touches on these matters is the “Case Study” dated April 5, 1999 prepared at Mr. Martini’s request by Mr. Fabian regarding how to improve SWI’s sales in the US. Counsel for the Respondent submitted that while the Case Study takes a 25% marketing fee as a given in the proposed scenarios, it does not address how that figure was determined. Counsel noted further that the evidence of Mr. Martini and Mr. Fabian was that, at the time the Case Study was prepared, no decision had yet been made as to the amount of the marketing fee. Mr. Martini said he had come up with the 25% formula based on his own business experience and observations of SWI’s performance in the US market prior to the implementation of the Barbados Structure. He candidly acknowledged that he had no documents to show how he had decided on the 25% marketing. He said he could not find any comparators but admitted that he had not sought professional advice to assist with that exercise.
 Counsel for the Respondent made a similar argument in respect of the determination of the 10% formula used in the MSSA Bonus Payment. While the exchange of correspondence between Mr. Csumrik and Mr. Martini shows that amount was requested and that Mr. Martini agreed to it subject to certain sales levels being met, it does not explain how the 10% amount was determined. Mr. Csumrik’s testimony was that there was no underlying rationale for that figure.
 In view of the above, the Respondent contends that the Appellant has failed to meet the requirements of subparagraphs 247(4)(a)(v) and (vi) is deemed not to have made reasonable efforts to determine and use arm’s length transfer prices and accordingly, is liable to a penalty in respect of the 2001 taxation year under subsection 247(3).
 The Appellant addressed the issue of penalties only briefly in oral argument. The submission of counsel for the Appellant in response to the Respondent’s position is reproduced in its entirety below:
My friend has suggested that the appellant has not satisfied the requirements under subsection 247(3) with respect to contemporaneous documentation. And we totally disagree with that. The letter that we sent on July 9th, 2003, which I believe — dated July 9, 2003 and can be found at tab 54. I’m not going to belabour the point. We went through it, what was enclosed in there. And at the end I note:
“I trust the foregoing is the information you require. If you need any elaboration on the enclosed material please don’t hesitate to give me a call.”
We heard nothing, nothing, for 11 months.
 This is not persuasive enough to overwhelm the force of the Respondent’s argument which in my view, is logically presented and well supported by the evidence. Accordingly, should a finding be required in respect of the application of subsection 247(4) after the Minister has made her reconsideration and reassessment, I find that the Appellant has failed to provide records or documentation that fulfil the requirements of subparagraphs 247(4)(a) and specifically, that the July 9, 2003 Response is not sufficient to satisfy subparagraphs 247(4)(a)(v) and (vi). Accordingly, the Appellant is deemed not to have made reasonable efforts to determine and use arm’s length transfer prices and is liable to a penalty in respect of the 2001 taxation year under subsection 247(3).
As a result the appeal was allowed, but only to the extent of permitting the deduction of fees in the amount of US$32,500 paid to SII in each of 2000 and 2001. Costs were awarded to the respondent.