McKesson Canada Corporation v. The Queen

McKesson Canada Corporation v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2013-12-13
Neutral citation
2013 TCC 404
File numbers
2008-2949(IT)G, 2008-3471(IT)G
Judges and Taxing Officers
Patrick J. Boyle
Subjects
Income Tax Act
Decision Content
Docket: 2008-2949(IT)G
BETWEEN:
MCKESSON CANADA CORPORATION,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
____________________________________________________________________
Appeal heard on common evidence with the appeal of
McKesson Canada Corporation 2008-3471(IT)G on October 17 to 20, 2011, October 25 to 28, 2011, October 31 to November 2, 2011,
November 15 to 18, 2011, November 29 to December 2, 2011,
December 12 to 15, 2011, January 16 to 20, 2012 and
January 31 to February 3, 2012 at Toronto, Ontario
Before: The Honourable Justice Patrick Boyle
Appearances:
Counsel for the Appellant:
Paul B. Schabas
Ryder Gilliland
Jeffrey Trossman
Ilan Braude
Kaley Pulfer
Counsel for the Respondent:
Guy Laperrière
Janie Payette
Sylvain Ouimet
Chantal Roberge
____________________________________________________________________
JUDGMENT
The appeal from the reassessment made under the Income Tax Act with respect to the Appellant’s 2003 taxation year is dismissed, with costs, in accordance with the attached Reasons for Judgment.
IT IS ORDERED THAT:
The parties are to file written submissions on costs within 30 days or such later date that the Court may agree to within that time. The written submissions are to include advising the Court whether a hearing on costs is requested.
The parties are to advise the Court within 30 days of their proposal for promptly addressing the proper identification for the Court of any confidential information in the Court record prior to public access to the record being reinstated. This may take the form of a Case Management Conference.
The parties are to advise the Court in writing within 3 days if they believe any confidential information is contained in the Court's Reasons for Judgment which should be addressed before being released to the public. Until then, the Reasons for Judgment are released to the parties and their counsel only and are not to be further disseminated by any party.
Signed at Edmonton, Alberta this 13th day of December 2013.
"Patrick Boyle"
Boyle J.
Docket: 2008-3471(IT)G
BETWEEN:
MCKESSON CANADA CORPORATION,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
____________________________________________________________________
Appeal heard on common evidence with the appeal of
McKesson Canada Corporation 2008-2949(IT)G on October 17 to 20, 2011, October 25 to 28, 2011, October 31 to November 2, 2011,
November 15 to 18, 2011, November 29 to December 2, 2011,
December 12 to 15, 2011, January 16 to 20, 2012 and
January 31 to February 3, 2012 at Toronto, Ontario
Before: The Honourable Justice Patrick Boyle
Appearances:
Counsel for the Appellant:
Paul B. Schabas
Ryder Gilliland
Jeffrey Trossman
Ilan Braude
Kaley Pulfer
Counsel for the Respondent:
Guy Laperrière
Janie Payette
Sylvain Ouimet
Chantal Roberge
____________________________________________________________________
JUDGMENT
The appeal from the reassessment made under the Income Tax Act with respect to the Appellant’s 2003 taxation year is dismissed, with costs, in accordance with the attached Reasons for Judgment.
IT IS ORDERED THAT:
The parties are to file written submissions on costs within 30 days or such later date that the Court may agree to within that time. The written submissions are to include advising the Court whether a hearing on costs is requested.
The parties are to advise the Court within 30 days of their proposal for promptly addressing the proper identification for the Court of any confidential information in the Court record prior to public access to the record being reinstated. This may take the form of a Case Management Conference.
The parties are to advise the Court in writing within 3 days if they believe any confidential information is contained in the Court's Reasons for Judgment which should be addressed before being released to the public. Until then, the Reasons for Judgment are released to the parties and their counsel only and are not to be further disseminated by any party.
Signed at Edmonton, Alberta this 13th day of December 2013.
"Patrick Boyle"
Boyle J.
Citation: 2013 TCC 404
Date: 20131213
Dockets: 2008-2949(IT)G
2008-3471(IT)G
BETWEEN:
MCKESSON CANADA CORPORATION,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
TABLE OF CONTENTS
1. Overview
2. The Financing Transactions
a) The RSA Discount Formula
(i) The Yield Rate
(ii) The Loss Discount
(iii) The Discount Spread
3. The TDSI Opinions on Arm’s Length Terms & Conditions and Pricing
a) Eligibility Criteria
b) Termination Events
(i) Delinquency Ratio Trigger
(ii) Loss Ratio Trigger
c) Discount Rate
(i) The Yield Rate
(ii) The Loss Discount
1. Designated Obligors
2. Other Obligors
(iii) The Discount Spread
1. Servicing Discount
2. Prompt Payment Dilutions Discount
3. Accrued Rebate Dilutions Discount
4. Interest Discount
4. TDSI’s Supplemental Report on Servicing Fees
5. The Law
(a) GlaxoSmithKline
(b) Reasonableness
(c) Relevant Series of Transactions
(d) Scope of Adjustments Permitted Under Paragraph 247(2)(c)
(e) Factors that Exist Only because of the Non-Arm’s Length Relationship
(f) The Rule in Browne v. Dunn and Opinions Within a Witness’ Expertise
(g) The Court’s Analytical Approach to be Followed in this Case
6. The Position of the Appellant
7. The Position of the Respondent
8. The Witnesses, the Expert Reports and the PwC Report
(a) Mr. Brennan
(b) Ms. Hooper and the TDSI Reports
(c) The PricewaterhouseCoopers Report
(d) The Frisch Expert Report
(e) The Reifsnyder Expert Report
(i) Factors One and Two – Servicing Fees and Prompt Payment Discounts
(ii) Factor Three – Credit Risk
(iii) Factor Four - $900MM Commitment to Finance
(f) The Becker Expert Report
(g) The Finard Expert Report
(h) The Glucksman Expert Report
(i) The Other Expert Reports
9. The Appropriate Methodology
10. Analysis of Transfer Pricing Issue
a) The Discount Rate
(i) The Yield Rate
(ii) The Loss Discount
(iii) The Discount Spread
1. Servicing Discount
2. Prompt Payment Dilutions Discount
3. Accrued Rebate Dilutions Discount
4. Interest Discount
b) Summary of Court’s Estimate of Discount Ranges
11. Conclusion on Transfer Pricing Adjustment
12. Timeliness of Part XIII Assessment of McKesson Canada
a) The Issue
b) The Provisions of the Income Tax Act and the Treaty
c) Position of the Parties
d) The Interpretation of Treaties
e) Analysis
f) Conclusion re: Part XIII and the Treaty
13. Dismissal of Appeals
Boyle J.
[1] The principal appeal by McKesson Canada Corporation (“McKesson Canada”) concerns the amount of the transfer pricing adjustment made by the Canada Revenue Agency (“CRA”) to its income under paragraphs 247(2)(a) and (c) of the Income Tax Act[1] (the “Act”) in respect of financial transactions involving McKesson Canada and several of its non-arm’s length and related non-Canadian affiliates during its 2003 taxation year. The related appeal involves the secondary issue of McKesson Canada’s liability under the Act for its failure to withhold and remit to CRA an amount equal to the Part XIII non-resident withholding tax from the disallowed amounts paid by it to its non-resident parent.
[2] As described in greater detail below, in 2002 it was decided by the McKesson Group that McKesson Canada would sell the receivables owing to it from its customers to a related non-resident McKesson Group entity at a discount. A facility was put in place pursuant to which the receivables would be transferred by McKesson Canada daily at a discount from the face amount of each transferred receivable.
1. Overview
[3] McKesson Canada is the principal Canadian operating company in the McKesson group of companies owned by the U.S. multinational McKesson Corporation (“McKesson U.S.”). McKesson U.S. is a United States public company and is the 15th ranking largest public company in the Fortune 20 list of companies. Its annual revenues are an excess of US$100 billion. It is the largest U.S. health care company. It has over 32,000 employees worldwide. It has been said that McKesson U.S. is the biggest company no one has ever heard of.
[4] Worldwide, and in Canada, the core business of the McKesson group of companies (“McKesson Group”) is the wholesale distribution of over-the-counter and prescription pharmaceutical medicine products. This accounts for about 97% of its revenues. Its other related business is that of hospital software technology.
[5] The McKesson Group’s wholesale pharmaceutical business has an impressive market share. The McKesson Group delivers one-third of all medicare to the public in the US. In the years in question, McKesson Canada had about one-third of the Canadian market. It distributes the products of a large range of pharmaceutical companies, and sells to drug store chains large and small, to large grocery store and department store chains that have pharmacies and/or sell over-the-counter medicinal products, to independent pharmacies, to hospitals, and to long-term care institutions.
[6] In the year the receivables facility was put in place, 2002, McKesson Canada had sales of $3 billion, profits of $40 million, 2,400 employees and the largest share of the Canadian market. Its Canadian customers included a number of Canada’s largest retailer grocers and drug store chains. It had credit facilities available to it in the hundreds of millions of dollar range with major financial institutions. Its public ultimate parent, McKesson U.S., had a solid investment grade credit rating and the interest rates on the available lines reflected that.[2] The McKesson Group had a very considerable cash surplus built up in its Irish affiliate.
[7] At that time, and in the years leading up to it, McKesson Canada had its own successful and sizeable credit department which managed its credit and collection policies and practices. Credit and collections results were trending favourably. McKesson Canada’s receivables were managed with considerable success, having a roughly 30 day payment average,[3] and a 0.043% bad debt experience[4] with its customers overall. That is, 99.96% of its receivables proved to be good and collected when managed by McKesson Canada’s credit department applying McKesson Canada’s credit and receivables collection policies. This was very important to McKesson Canada’s success given that the wholesale drug business was low-margin – in the range of 2% - on high volumes.
[8] There was no evidence that there was any pending imminent or future change expected, anticipated or planned for in the make-up, nature or quality of McKesson Canada’s receivables or customers, although there was always the future risk of unforeseen adverse change.
[9] At that time, McKesson Canada had no identified business need for a cash infusion or borrowing, nor did McKesson Group need McKesson Canada to raise funds for another member of the group. There was a so-called double-dip Nova Scotia Unlimited Liability Company or ULC financing which was coming to maturity and would need to be recapitalized in some fashion; this was for a fraction of the amount of the new receivables facility. McKesson Canada did not approach its traditional lenders or conventional financial institutions (nor anyone else) before entering into its own non-arm’s length receivables facility and related transactions. The McKesson Group had previously put in place a tax-effective international corporate structure and inter-group transactions that allowed it to amass very large amounts of cash in Ireland. The non-Canadian members of the McKesson Group were able to use this money to finance all of the purchases of McKesson Canada’s receivables under the facility.
[10] The non-Canadian McKesson Group company that purchased the receivables had the right to put non-performing receivables back to McKesson Canada for a price equal to 75% of the face amount, later readjusted to the amount actually collected on it by McKesson Canada. The purchaser did not otherwise have recourse to McKesson Canada for unpaid purchased receivables.
[11] The non-Canadian McKesson Group entity that purchased the receivables borrowed all the money needed from another non-Canadian McKesson Group entity. The borrower’s obligations to the lender under the loan was fully guaranteed by yet another non-Canadian McKesson Group entity, which also indemnified the borrower for any shortfall between what the borrower received from McKesson Canada’s receivables and what it needed to pay on the loan.
[12] As described below, the non-resident affiliate also paid McKesson Canada to continue to have McKesson Canada’s credit and collections department manage the receivables applying McKesson Canada’s credit and receivables collection policies and practices. Under the agreements these policies and practices could not be changed without consent. Similarly, McKesson Canada could only continue to grant other discounts or rebates in the ordinary cause of its business and in accordance with its usual practices when the facility was entered into.
[13] Most of the proceeds of the initial $460,000,000 receivables sale were returned by McKesson Canada to its non-resident shareholder affiliate, a portion was loaned for a period to another Canadian corporation to permit its tax losses to be used, and about 1% of the proceeds were used by McKesson Canada for its general corporate purposes.
[14] The CRA has challenged these related party transactions for McKesson Canada’s 2003 taxation year on the basis that the amounts paid to the non-Canadian McKesson entity pursuant to the receivables purchase transactions differ from those that would have been paid between arm’s length persons transacting on arm’s length terms and conditions. The discount upon the purchase of the receivables in accordance with the revolving facility was a 2.206% discount from the face amount. While this discount rate and the overall transactions between the parties are considered in greater detail below, this discount rate for receivables that on average were expected to be paid within about 30 days can be restated as an annual financing cost payable by McKesson Canada for its rights under the facility in the range of 27% per annum.[5]
[15] A direct result of these discounts was that McKesson Canada ceased to be profitable for its 2003 taxation year and reported a tax loss in the year in issue in this appeal. McKesson Canada’s profits in later years were similarly significantly reduced.
[16] The taxation year of McKesson Canada under appeal ending March 29, 2003 was a short taxation year of approximately three and a half months, having started upon its amalgamation as part of a Canadian restructuring of the McKesson Group’s Canadian interests. Its taxation and financial year ends on the last Saturday in March of each year. Its financial year is divided into a 13 four week Accounting Periods. CRA’s 2003 transfer pricing adjustment was approximately $26,610,000, reflecting a 1.013% discount for the purchased receivables.[6] No transfer pricing penalty was assessed.
[17] The receivables facility was a five-year revolving facility. As detailed below, the purchaser had several rights to terminate the agreement in the event of any anticipated deterioration in the quality of receivables generated in McKesson Canada’s business.[7]
[18] As discussed further below, the predominant purpose of McKesson Canada entering into the transactions was the reduction of its Canadian tax on its profits. None of the raising or freeing up of capital, reducing credit risk from its customers, nor improving its balance sheet was McKesson Canada’s predominant purpose; they were results of the transactions.
[19] This trial was a very lengthy and hard fought 32 day trial heard over a period of five months from October 2011 to February 2012. Formidable groups of lawyers represented each of the Appellant and the Crown. The Court heard from two material witnesses and five expert witnesses. Reams and reams of documentation were entered into evidence, including further expert reports whose authors did not testify. After oral argument both parties made further written submissions and further responding submissions. Following the Supreme Court of Canada’s decision in Canada v. GlaxoSmithKline Inc., 2012 SCC 52, [2012] 3 S.C.R. 3 in October 2012, both parties made further written submissions.[8]
2. The Financing Transactions
[20] McKesson Canada and its Luxembourg immediate parent company (“MIH”) entered into a Receivables Sales Agreement (the “RSA”) and a Servicing Agreement effective December 16, 2002.
[21] Under the RSA, MIH agreed to purchase all of McKesson Canada’s eligible receivables as at that date (about $460,000,000) and committed to purchase all eligible receivables daily as they arose for the next five years unless earlier terminated, and subject to a $900,000,000 cap.
[22] Eligible receivables were generally trade receivables owing by an arm’s length customer who was not in default on other receivables and whose receivables would not, except in specific circumstances described below, represent in the aggregate more than 2% of the then outstanding receivables pool. The 2% concentration limit on eligibility did not apply to McKesson Canada’s handful of its largest named customers who accounted for about one-third of sales and whose receivables each already exceeded 2% of McKesson Canada’s outstanding receivables pool (the “Designated Obligors”). All hospitals were also defined to be Designated Obligors. The RSA has specific provisions, including discount rate calculation considerations, applicable to these Designated Obligors. The RSA contemplated the 2% concentration limit being waived or additions being made to the list of Designated Obligors with MIH’s consent.
[23] The RSA provided that if a termination event occurred, MIH could direct McKesson Canada to advise its customers of the sale. In accordance with the related Servicing Agreement, McKesson Canada would continue to service and collect the receivables in accordance with its credit and collection policies and practices which were not to be changed without the consent of MIH.
[24] The Servicing Agreement provided that McKesson Canada was to be the initial servicer but could be replaced upon the occurrence of a termination event under the RSA. MIH agreed to pay a fixed annual fee of $9,600,000 to the servicer to service the outstanding transferred receivables regardless of the amount outstanding.[9]
[25] McKesson Canada did not warrant or guarantee the collectibility of the receivables or any portion thereof. MIH had the right to put a defaulted receivable back to McKesson Canada for an amount equal to the lesser of (i) 75% of its face amount, and (ii) the amount ultimately collected on it. When exercised, McKesson Canada was to pay the 75% amount to MIH and any ultimate downward adjustment was to be made subsequently.
[26] MIH could terminate its obligations to purchase any further McKesson Canada receivables upon the occurrence of certain defined termination events, generally designed to identify or anticipate deteriorating creditworthiness of McKesson Canada or its pool of customers generating the receivables. These events included financial defaults of McKesson Canada or its affiliates, increases in the delinquency ratio or loss ratio of the receivables beyond specific thresholds, a downgrade in the credit rating of McKesson U.S., McKesson Canada’s name being changed to drop the word McKesson, McKesson Canada ceasing to be controlled by McKesson U.S., McKesson U.S. ceasing to guarantee McKesson Canada’s bank and commercial paper lenders, and any event occurring which materially adversely affected the enforceability or collectibility of the receivables or MIH’s rights under the agreements.[10] It can be noted that the termination events were not limited to things in McKesson Canada’s control, and included events in the control of its direct and indirect shareholders/parent corporations.
[27] McKesson Canada continued to collect the receivables in the ordinary course. While ownership of the receivables was transferred daily, settlement (i.e. payment by the purchaser MIH) was more or less monthly.[11] McKesson Canada was not required under the RSA or the Servicing Agreement to segregate the funds collected on MIH’s behalf as they came in, unless MIH required it following a termination event. Each month the amount collected on the receivables for MIH’s benefit would be used first to pay McKesson Canada for newly generated receivables and any balance would be remitted to MIH. If there was a shortfall because newly originated receivables exceeded amounts collected, MIH was required to put McKesson Canada in funds.[12]
[28] While the RSA was for up to a five-year term, it was clearly a revolving facility. Purchased receivables could be expected to be collected by MIH within about a month. MIH could be expected to know within a short period of time if any obligor’s payment history or prospects were declining or deteriorating, or if McKesson Canada’s creditworthiness was declining or deteriorating, and could take immediate steps to protects its interests and its future exposure, without waiting five years.
[29] The RSA provided that McKesson Canada would pay MIH’s costs and expenses related to the transactions, including the costs of an inter-company transfer pricing study.[13]
[30] The RSA provided that the purchase price payable by MIH to McKesson Canada for each receivable would be at a formulaically determined discount from its face amount. This is described in greater detail immediately below.
[31] Any dilution or reduction to the face amount of a receivable resulting from discounts, rebates, disputes or returns, or by way of set-off under the terms of the receivable or otherwise, were deemed collections by McKesson Canada as servicer and to be accounted for to MIH as such. This did not apply to prompt payment discounts for reasons that were not directly explained in the evidence. The scope and nature of how the dilution risk relating to prompt payment discounts is dealt with under the agreements is in issue in this appeal.
[32] During the term of the RSA it was discovered that interest received on the transferred receivables had not been accounted for and was retained by McKesson Canada. This was not consistent with the RSA.[14] The parties agreed not to account for the past error or to correct it going forward. In 2005, the parties agreed in writing that the interest and late payment charge obligations on the transferred receivables were never intended to be transferred – something that is difficult to reconcile with the RSA language or on any arm’s length basis.
[33] The agreements are governed by Luxembourg law.
[34] MIH, McKesson Canada’s direct parent, borrowed all of the money in Canadian dollars to purchase the receivables from an Irish company in the McKesson Group (alluded to above), that was one of its indirect parents. The purchase of receivables under the RSA was MIH’s stated use of the funds in its loan agreements. The interest payable by MIH was a direct function of the discount enjoyed by it under the RSA. MIH’s obligation to repay its borrowings to its Irish affiliate was fully guaranteed by its indirect parent, another related Luxembourg company (“MIH2”). In addition, MIH enjoyed an indemnity from MIH2 under a Memorandum of Understanding for any amounts payable in accordance with the RSA that were not received from McKesson Canada in order to allow MIH to fully re-pay its borrowings from its Irish affiliate.[15] MIH, McKesson Canada’s counter-party to the RSA and the Servicing Agreement, did not take any financial risk under this group of contemporaneous, inter-woven agreements all of which were financially and legally linked and related. All such risk was borne by other entities in the McKesson Group. That risk ultimately remained economically with McKesson U.S., everyone’s ultimate parent company, both before and after the RSA transactions.
a) The RSA Discount Formula
[35] The amount payable for a purchased receivable under the RSA was the product obtained from multiplying (i) the face amount of the receivable and (ii) one minus the Discount Rate expressed to four relevant digits.[16] By way of illustrating the method in which this formula worked, if the Discount Rate (as defined itself by a further formula) worked out to 0.0150, MIH would pay $98.50 for every $100 of receivables[17], buying them at a 1.5% discount from face.
[36] The Discount Rate is defined in the RSA to be the sum of (i) the Yield Rate, (ii) the Loss Discount, and (iii) the Discount Spread.
(i) The Yield Rate
[37] The Yield Rate was the 30 day Canadian dollar bankers’ acceptance (BA) rate, or CDOR,[18] on the first business day of the relevant settlement period. This operated as the floating base rate. This was intended to reflect a current, risk-free market rate of return. It is not challenged as an appropriate floating base rate for this Canadian dollar, Canadian obligor transaction.
(ii) The Loss Discount
[38] The Loss Discount was intended to reflect the credit risk of the McKesson Canada customers who were the receivables debtors. The Loss Discount was made up of two parts: (i) a Loss Discount component applicable to the Designated Obligors (whose receivables each exceeded 2% of the pool) and (ii) a Loss Discount component applicable to the other smaller Obligors making up the more diversified majority of the receivables pool.
[39] The RSA expressed a fixed Loss Discount of 0.23% applicable to the initial purchase of receivables in 2002 to the end of 2003. This applied to the year under appeal.
[40] For the remaining term, the Loss Discount was to be recalculated each year starting January 1, 2004. Also, if at any time MIH felt that the ratio of Designated Obligors’ receivables to other Obligors’ receivables in the pool was materially different than originally calculated for a year, MIH could require the Loss Discount to be recalculated that month. McKesson Canada as seller did not have any similar right. The result was that the RSA required the Loss Discount to be recalculated annually, and permitted only MIH to require it to be recalculated as often as monthly in the event of such a material change in risk.
[41] For the larger Designated Obligors, a schedule to the RSA fixed their Individual Loss Discounts for the entire five-year period. In computing the aggregate Loss Discount for Designated Obligors, the weighted average of these fixed Individual Loss Discount amounts (weighted by each Designated Obligor’s share of the receivables pool as at the end of the prior year) was used. Since the Individual Loss Discounts were intended to reflect the unique credit risk of each Designated Obligor, there was a considerable range within the scheduled amounts (ranging from approximately 0.04% to 0.35% - a nine-fold range).
[42] For each of the other Obligors (comprising about two-thirds of the pool), the RSA fixed an Individual Loss Discount at 0.2380% for the entire five-year term. The mechanics of how this number was arrived at was not apparent from the RSA as the agreement simply stipulated a fixed number for the entire duration. In computing the Loss Discount for these other Obligors, the weighted average of this fixed 0.2380% (weighted by the total of these other Obligors’ share of the receivables pool as at the end of the prior year) was used.
[43] The Loss Discount was the sum of the weighted Individual Loss Discount for all Obligors.
[44] The initial fixed Loss Discount of 0.23% applicable to the first full year was in fact calculated on this same basis. The amount thereof is significantly in issue in this appeal.
(iii) The Discount Spread
[45] The RSA fixed the Discount Spread at 1.7305% for the entire duration of the agreement. Since this was fixed, the agreement does not describe how this number was arrived at. The evidence is that generally this relates to (i) the risk that McKesson Canada’s creditworthiness deteriorated significantly, and receivables debtors might set off their rebate entitlements in such event, (ii) the risk that McKesson Canada’s customers might increase their take-up of available prompt payment discounts, (iii) the risk that MIH might decide to appoint a new servicer following any termination event who might require a greater servicing fee than provided for successor servicers in the Servicing Agreement and (iv) the need for the Discount Rate to fully cover MIH’s cost of funds.
[46] There was no corresponding consideration given to the possibility of McKesson Canada’s creditworthiness improving, customers taking less advantage of prompt payment discounts, or the impact of more prompt payments on the DSO. These imbalances were never explained.
[47] This 1.7305% amount, it being a fixed amount, and the extent of MIH’s exposure to McKesson Canada credit risk under the agreements in the circumstances, are also significantly in issue in this appeal.
3. The TDSI Opinions on Arm’s Length Terms & Conditions and Pricing
[48] The RSA and all related agreements were first signed as of December 16, 2002. The conception, structuring, planning and drafting was under way for an unknown amount of time before that. This process seems to have been lead primarily by the Vice-President of Taxes of McKesson U.S., together with the tax and banking lawyers at Blake, Cassels & Graydon LLP (“Blakes”). Some general transfer pricing advice on approaches to, and issues in, structuring such a transaction was obtained in the summer of 2002 from Horst Frisch, a U.S. consulting company specializing in transfer pricing.[19] McKesson Canada’s role was limited to providing support and information regarding such things as its customers, its receivable portfolio, its projections, and its credit and collection policies et cetera.
[49] In the weeks before the signing of the agreements, probably around December 1, 2002, Toronto Dominion Securities Inc. (“TDSI”) was retained by Blakes to provide advice on certain arm’s length aspects of certain of the terms and conditions of the RSA and of certain components of the discount calculation. The TDSI engagement letter was sent to TDSI on December 3rd. It is clear from TDSI’s advice that by the time that TDSI was consulted, the structure and pricing approach and formulae were largely settled. It is not clear that any significant changes were made to these to reflect any advice or information given by TDSI. This is consistent with the testimony of Mr. Hooper of TDSI.
[50] It can be noted that in 2002 the Act included contemporaneous arm’s length transfer pricing documentation/analysis requirements to defend the 10% transfer pricing penalty provisions. In fact, the TDSI opinions were relied on as the only contemporaneous basis to successfully contest CRA’s pre-reassessment proposal to impose transfer pricing penalties.[20]
[51] TDSI’s advice was initially sought on (i) receivables eligibility criteria (ii) termination events/triggers and (iii) the appropriateness of the discount pricing. Somewhat oddly and not explained, Blakes’ engagement letter specifically identifies and raises the possible need to address the effect of a potential replacement servicer under the Servicing Agreement as part of the discount.
[52] McKesson Canada had a pre-existing business relationship with the Toronto Dominion Bank group. The full scope of that was not put clearly in evidence, however, several years earlier, McKesson Canada had done a receivables factoring transaction with TD Factors. The TD Factors transaction was an entirely tax-driven year-end short-term transaction designed to avoid Canadian federal capital tax and seems to have been priced accordingly. It is entirely unreasonable to suggest this was a truly comparable transaction for arm’s length pricing purposes to the one in issue in this appeal.
[53] Barbara Hooper is the person at TDSI that Blakes chose to contact. She was known to be a senior member of TDSI’s securitization group. Her advice was sought notwithstanding that everyone knew the RSA and related transactions were not structured as securitization transactions, were not intended to be securitization transactions, and that the purpose, objective and characteristics of the RSA transactions were significantly and materially different than a securitization transaction. No advice or information was sought from anyone other than the TDSI securitization group (and the TD bond traders briefly and casually consulted by Ms. Hooper’s group.)
[54] Barbara Hooper was and is clearly a recognized professional and experienced expert (as a business person would use that word) in securitization matters, including trade receivables securitizations. She testified in this hearing as a material witness and not a qualified expert witness. Since her role as a material witness in offering the TDSI opinions involved her exercise of her professional judgment, she was allowed to fully explain in her testimony those opinions, including her reasons, and her supporting information, bases and subsidiary opinions.
[55] Clearly Ms. Hooper’s experience with trade receivables securitizations qualified her to give valuable advice to the McKesson Group entities participating in the transaction and to the Court. She is certainly very knowledgeable about the risks associated with transfers of trade receivables, how those risks can be identified, and how those risks can be minimized in a receivables securitization transaction. Her experience and expertise did not however extend to pricing those risks if the risks were to be transferred, nor did it extend to market discount rates applicable to outright non-recourse or limited recourse sales or factoring of trade receivables. She did not hold out or suggest otherwise in the TDSI opinions or in her testimony.
[56] Her testimony and TDSI’s involvement in the RSA transactions have been helpful to the Court. The TDSI opinion followed the conceptual approach dictated by the RSA presented to it by the McKesson Group. As is often the case with expert and other opinion evidence, the Court found much of the detailed explanation and reasoning behind the opinions, as well as some of the data and information supporting the opinions, helpful notwithstanding that the Court does not arrive at entirely the same conclusion in the end.
a) Eligibility Criteria
[57] The TDSI opinion deals with this in a single short three-sentence paragraph. It concludes, without explanation or analysis, that the definition of eligible receivables in the RSA is within the range of normal in an arm’s length transaction of this nature. While it uses the words “transaction of this nature”, I can only conclude this is a reference to a securitization transaction involving receivables given the description of the experience TDSI brought to bear.
[58] It goes on to identify that the exposure to the receivables pool concentration levels associated with McKesson Canada’s Designated Obligors would not be present in a securitization, will need to be addressed by TDSI in addressing the Discount Rate, and that this component of the Discount Rate will need to be dynamic, reflecting possible changes in the relevant balance of Designated Obligor receivables in the pool from time to time.
b) Termination Events
[59] TDSI is satisfied that the triggers in the RSA definition of termination event are within the range of normal in an arm’s length transaction “of this nature”. I repeat my earlier observations about her use of this phrase in the TDSI opinion.
[60] The TDSI opinion makes specific reference to the role of such termination triggers as protection for poor performance of receivables or declining creditworthiness of the seller. It identifies McKesson Canada’s creditworthiness as seller as relevant in part because of its obligations to remit collections to MIH. TDSI is of the express view that “because [McKesson Canada] is so closely tied and important to [McKesson U.S.], it is reasonable to use the public debt ratings of [McKesson U.S.] as an indication of [McKesson Canada’s] creditworthiness”.
[61] The TDSI opinion goes on to specifically consider i) the receivables pool’s delinquency ratio trigger in the RSA, and ii) the receivables pool’s loss ratio trigger in the RSA.
(i) Delinquency Ratio Trigger
[62] TDSI considered the improving two year historical trend in the delinquency ratio of McKesson Canada’s receivables and the recently maintained 1.0% rate. The 2.5% trigger rate in the RSA would, in TDSI’s opinion, represent a significant adverse deviation from the current steady state of 1% and so considered reasonable. TDSI highlighted the importance of the dynamic four-month rolling average approach to measuring the delinquency ratio in the RSA, and uses this approach in its analysis. TDSI confirmed that this is consistent with the three to six month periods generally used for such purposes.
(ii) Loss Ratio Trigger
[63] TDSI looked at three years of historic bad debt experience on McKesson Canada’s receivables portfolio. TDSI identified the difference between accounting write-offs and the 90 day delinquency definition of losses for purposes of the loss ratio in the RSA, with the result that the latter ratio could be expected to exceed the former. TDSI opined that a dynamic loss ratio, which measured a four-month average 90 day delinquency, and with a trigger of 0.25%, appeared reasonable given that, although write-offs to sales on a monthly basis at times reached this level, it had never exceeded 0.10% on a four-month rolling average.[21]
c) Discount Rate
[64] The TDSI Report says its assessment of the appropriate compensation was set by (i) where possible, looking at pricing of comparable risks in the market and (ii) “where pricing comparables were unavailable, we assessed the potential cost to [MIH] of assuming the risk”.[22]
[65] In its summary paragraphs on the total discount at the end of its report, TDSI addressed the total discount following the RSA definition of Discount Rate as the sum of (i) the Yield Rate, (ii) the Loss Discount, and (iii) the Discount Spread. In summarizing the TDSI Report on the Discount Rate, it is easiest for the Court to follow this same order in its Reasons rather than the different order more loosely followed in the body of the TDSI Report.
(i) The Yield Rate
[66] TDSI identifies that the RSA used the 30 day Canadian dollar CDOR/BA Rate as the floating base rate component and that the 30 day CDOR Discount Rate needs to be adjusted to reflect the receivables’ DSO.
[67] Notwithstanding the definitions of Discount Rate and Yield Rate in the RSA (even after it was amended and restated, and after being further clarified), the Court observes that the Yield Rate component of the Discount Rate in fact needs to be adjusted to reflect that the 30 day CDOR Rate is expressed as an annual rate and therefore needs to be adjusted to reflect the receivables pool’s DSO by multiplying it by the DSO and then dividing by 365.
[68] TDSI selected the receivables pool’s three year average monthly DSO it calculated as 32. There was no discussion of why a shorter period’s average monthly DSO was not used, nor was there any discussion in the TDSI Report of a dynamic rolling average approach to DSO.
[69] TDSI recognized that the DSO for the initial purchase of approximately $460,000,000 of receivables would very significantly overstate the expected payment term for these receivables as they were a pool of mature short-term receivables (i.e. some would be paid the following day because they had been outstanding for between 1 and 30 days or more).
[70] TDSI’s approach was to instead use a 16 day DSO for the