Unfair Pricing

Ford Motor Co. likely didn't imagine its "squeeze out" offer to the minority shareholders of its Canadian subsidiary still would be in limbo 11 years after the initial offer in 1995.

Indeed, no one could have blamed Ford for being somewhat smug when Ford Motor Co. of Canada's (Ford Canada) minority shareholders sued Ford for using an unfair internal transfer-pricing system (TPS)--the mechanism by which conglomerates allocate profits between their various corporate entities--to dilute Ford Canada's value. After all, the multinational's TPS had been in place since 1965, and both the Canada Revenue Agency and the IRS had approved the arrangements.

Ford may have been smug, but as it turns out, inappropriately so. The Ontario Court of Appeal ruled in January 2006 that Ford's TPS had been unfair to minority shareholders. The ruling opens the possibility that Canadian tax authorities will re-examine Ford Canada's TPS back to 1985, adding millions and perhaps billions of dollars to the Canadian subsidiary's tax liabilities.

That is making other multinationals that have intra-corporate pricing arrangements with their Canadian subsidiaries nervous that they too will be subject to increased tax liability.

"The case certainly sets the stage for reassessment because it represents Canadian courts' most extensive judicial consideration of transfer pricing," says Robert McMechan, a TPS expert and sole practitioner in Ottawa.

Ford's Pricing Scheme

Ford had very little reason to suspect that there was anything wrong with its pricing practices--after all it had been exchanging goods and services with Ford Canada since 1904. Ford created the modern version of its internal TPS after the 1965 automotive free trade pact between Canada and the U.S., which allowed Ford to integrate its North American businesses. From 1965 to 1977, the TPS worked well for a prospering Ford Canada. But for 19 consecutive years after that, the company lost money. Between 1985 and 1995 (the period at issue in the litigation) the losses amounted to $709 million. Conversely, Ford had $29 billion in profits over the same period, of which $6 billion came from transfer payments made by the Canadian subsidiary.

In 1995, Roy Bennett, the former CEO of Ford Canada, expressed concern to the boards of both companies that his company's minority shareholders were being treated unfairly because the multinational's TPS was contributing substantially to the losses. At the time, Ford held 94 percent of the shares in Ford Canada, with Ontario Municipal Employees Retirement Board (OMERS) and other minority shareholders holding the rest.

Bennett's concern prompted Ford to seek a buy-out of the minority shareholders at $185 per share. The minority shareholders objected to the price, forcing Ford to seek a declaration of fair value from the Ontario Superior Court. At trial, the shareholders--led by OMERS, Canada's largest pension fund--claimed they had been unlawfully oppressed from 1985 to 1995 by an improper TPS scheme.

The Courts Rule

In January 2004, Justice Peter Cumming ruled that Ford's TPS was faulty because Ford Canada would never have agreed to the TPS if it wasn't affiliated with Ford.

"Cumming noted it was not sufficient for a taxpayer to simply have a transfer-pricing system to which the tax authorities do not object," McMechan said. "He made it clear that the system must also be fair to minority shareholders."

While it was true that the Canada Revenue Agency hadn't objected to the TPS, the agency hadn't conducted a full audit or a detailed evaluation.

"In other words, just because it appears in hindsight that the Canada Revenue Agency screwed up doesn't change the requirement that the TPS must treat minority shareholders fairly," McMechan says.

Had an arm's-length agreement been in place, Cumming concluded, the value of the shares would have been $582.50. But the Limitations Act, which puts strict time limits on the period for which the minority shareholders could recover, reduced the plaintiffs' maximum recovery to $260.

Citing technical deficiencies in proof of the dates on which various minority shareholders had held their shares, the Court of Appeal reduced the shareholders' recovery somewhat, but otherwise substantially upheld Cumming's judgment on the transfer-pricing issue--leaving the field wide open for Canada Revenue Agency reassessments of Ford and other multinationals.

And there's little doubt that the Canada Revenue Agency will take interest.

"The Department of Justice [whose lawyers represent the Canada Revenue Agency's interests] even had people attending the hearings in this case," says Frank Newbould, a partner in Borden Ladner Gervais' Toronto office. "Every U.S. subsidiary not wholly owned by the parent will have to reconsider its transfer-pricing system."

As it turns out, the agency is armed and ready.

TPS Under Review

According to McMechan, it's only in the past decade that Canada Revenue Agency has had the resources to conduct widespread and thorough TPS audits.

"There has been an enormous beefing up of the agency's international tax capability," he says. "Before 1995, there were virtually no international tax auditors and now there are hundreds."

So much so, McMechan says, that TPS audits are now common.

"The growth has been so explosive that every company should expect to have a transfer-pricing examination by the Canada Revenue Agency sooner or later," he says.

The Supreme Court is currently considering a leave-to-appeal application from OMERS, which is dissatisfied with the Court of Appeal's reduction of Cumming's award. However, a decision on granting leave, which also would involve a review of the TPS issue, may not come until October.

But that doesn't mean companies should be passive.

"Transfer-pricing advisers and their clients who ignore the case do so at their peril," says Scott Wilkie, a tax partner at Osler, Hoskin & Harcourt. "Rather, they should see this case as a reminder to fully articulate the external factors that give the agreements they draft the characteristics of arm's-length arrangements."

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Julius Melnitzer

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