SCC Tax Cases 2012 in Review: The Death of Moldowan and the First Transfer Pricing Decision

April 17, 2013 | David W. Chodikoff

There are only a few tax cases that make it to the Supreme Court of Canada (“SCC”). Indeed, any party that has sought leave to appeal to the SCC knows only too well that it is an exceptionally difficult task. In 2012, there were three SCC tax decisions: Canada v. Craig, 2012 SCC 43 (“Craig”) farming loss case, Canada v. GlaxoSmithKline Inc. 2012 SCC 52 (“Glaxo”) transfer pricing case, and Garron Family Trust (Trustee of) v. R., [2012] 1 S.C.R. 520 trust residence case. This article reviews the Craig and Glaxo decisions.

SCC’s Decision in Farming Loss Case

In Craig, the taxpayer’s principal source of income was his professional income from the practice of law. He was also involved in the business of buying, selling, training and maintaining horses for racing. Throughout the court process, the central issue was the application of subsection 31(1) of the Income Tax Act (Canada) (the “Act”). Subsection 31(1) of the Act provides that if the taxpayer’s chief source of income for a particular taxation year is neither farming nor a combination of farming and some other source of income, the taxpayer’s farm loss deduction for a particular taxation year is limited to $8,750.

Since the SCC decision in Moldowan v. M.N.R., [1978] 1 SCR 480 (“Moldowan”) (now over 30 years ago), the rule had been that for the provision not to apply in the case where the taxpayer’s chief source of income is a combination of farming and other sources of income, farming must be the predominant source of income in relation to other sources of income. However, both courts and tax commentators have criticized this narrow interpretation. Critics concluded that the Moldowan approach appeared to “read out” words in the Act with the result that the second exception was rendered meaningless.

Remarkably, the SCC in Craig reversed itself declaring that its earlier decision in Moldowan was wrongly decided. Overturning one of its own decisions is an extremely rare step for the SCC. The SCC justified this course of action on several grounds. However, the key point was that the SCC finally recognized that having regards to the words of subsection 31(1) of the Act, there are effectively two exceptions to the loss deduction limitation and each must be given its meaning.

The SCC applied a two-step test to determine whether Mr. Craig qualified for the second exception in subsection 31(1). The SCC held that a court must first determine if the farming operation is actually a business and not a personal or hobby-like endeavour. Second, should the court determine that the farming operation is a business then the taxpayer is permitted to deduct all of his farming losses against his income provided that the farming and other source of income is the taxpayer’s chief source of income. This second step requires a court to consider the taxpayer’s capital investment in the farming operation and the other earning activity, the time spent by the taxpayer on the farming operation and other earning activity, the income from the farming operation and the other earning activity, and the taxpayer’s ordinary mode of living, farming history and future intentions and expectations.

The SCC indicated that the overall approach in applying the two-step test must be flexible and recognize that not each factor needs to be significant. Based on a review of all these factors, if it is determined that a taxpayer places significant emphasis on each of the farming business and the other earning activity, the second exception in subsection 31(1) should apply and the farming loss should not be subject to the loss deduction limitation.

Given this new two-step test, the SCC concluded that the Tax Court of Canada (the “TCC”) decision was correct and agreed that Mr. Craig was entitled to deduct farming losses of $222,642 and $205,655 in the 2000 and 2001 taxation years, respectively.

The 2013 Canadian Federal Budget proposes to restore the Moldowan test requiring that a taxpayer’s other sources of income must be subordinate to farming in order for farming losses to be fully deductible against income from those other sources. It is also proposed that the restricted farm loss limit will be increased to $17,500 of deductible farm losses annually ($2,500 plus ½ of the next $30,000). These proposed measures will apply to taxation years ending on or after March 21, 2013.

SCC’s Decision in Transfer Pricing Case

Glaxo is the first transfer pricing case heard by the SCC. Since the taxation years under review were 1990 to 1993, the applicable provision in this case was subsection 69(2) of the Act. Subsection 69(2) has now been replaced with subsection 247(2) of the Act for taxation years and fiscal periods that begin after 1997.

Glaxo involves the purchase of ranitidine, the active ingredient in the anti-ulcer medication commonly known as Zantac, by GlaxoSmithKline Inc. (“GlaxoCanada”) from a non-arm’s length Swiss-based company which was part of the Glaxo group of companies. Glaxo was granted certain rights and obligations in relation to the manufacture and sale of Zantac in Canada under a non-arm’s length License Agreement and Supply Agreement. Pursuant to the terms of these two agreements, Glaxo was required to purchase ranitidine from a non-arm’s length company in the Glaxo group at a price varying between $1,512 and $1,651 per kilogram for ranitidine whereas ranitidine from other sources was available and purchased by generic drug companies for a price varying between $194 and $304 per kilogram. Effectively, Glaxo paid approximately 5 times more for the ranitidine than generic drug companies.

The issue before the TCC was whether the amount paid by GlaxoCanada to the non-arm’s length company was reasonable in the circumstances. The TCC found that the comparable uncontrolled price (“CUP”) method should be used to test the reasonableness of the price paid in this case and that the appropriate comparable was the highest price paid by the generic drug companies. On that basis, the TCC concluded that the price paid by GlaxoCanada was not reasonable and dismissed GlaxoCanada’s appeal. In arriving at its decision, the TCC did not take into account the rights and benefits under the Licence Agreement.

The Federal Court of Appeal (“FCA”) reversed the lower court’s decision. The FCA found that the Licence Agreement was “central to GlaxoCanada’s business reality” and that it should be taken into account in determining whether the price paid by GlaxoCanada for ranitidine was reasonable. The FCA remitted the matter to the TCC for redetermination of the “reasonable” transfer price.

The Minister appealed and GlaxoCanada cross-appealed the FCA decision to the SCC. The SCC agreed with the FCA and concluded that the TCC incorrectly decided not to take into account the Licence Agreement. By refusing to consider the impact of the Licence Agreement, the SCC held that the TCC wrongly found that the prices that the generic drug companies paid for ranitidine were comparable. The SCC dismissed both the appeal and the cross-appeal and remitted the matter back to the TCC for the redetermination of the “reasonable” transfer price with the direction that the Licence Agreement is a relevant consideration in respect of the prices paid by GlaxoCanada for the supply of ranitidine.

The SCC decision dealt with many aspects of transfer pricing analysis. A key take-away is the statement “transfer pricing is not an exact science” and the trial judge should be afforded deference and “some leeway in the determination of the reasonable amount”. The decision also highlights factors that all parties should consider in determining appropriate transfer prices in non-arm’s length transactions. Given the outcome and more precisely, the Reasons for Judgment, the Glaxo decision will hardly be the last SCC words on transfer pricing. Stay tuned.


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