Canada: Transfer Pricing for Canadian Owner-Managed Businesses – Not Just a Big Company Issue!

For many, the phrase "transfer pricing" may conjure up recollections of newspaper articles or court cases about large multinational enterprises (MNEs). The main story line often highlighted how these large companies purportedly planned their affairs to place profits in targeted tax jurisdictions, including one or two tax havens, thereby purportedly minimizing their global tax burden. This tax minimization was typically described as having been accomplished through transfer pricing. Tax minimization is not just a big business objective. It is a goal for owner-managers too.

Global expansion may include the initial launch of operations as well as the development of self-sustaining manufacturing and distribution operations in a foreign country. Each stage of international expansion presents its own array of transfer-pricing issues and opportunities. This paper addresses the topic of transfer pricing from a Canadian perspective as it specifically relates to small- or medium-sized businesses as they expand globally. Ultimately, the transfer-pricing issues are no different from those faced by MNEs. However, owner-managed businesses typically have limited resources, financial or administrative, available to address these issues before expanding into the international marketplace.

Worldwide tax planning, focusing on both the short-term and the long-term, is critical to maximizing one's future success. Today's decisions affect tomorrow's results and choices. One key step is to plan ahead and mimic arm's-length arrangements in all cross-border dealings - that includes documenting and supporting what has been done or is about to be done. Transfer pricing is a global planning tool that, if given proper attention, can create opportunities and contribute to the minimization of one's effective rate of global tax.

This paper* is not intended to be a recitation of transfer-pricing theory; however, a brief summary and references to current authoritative sources are provided. Our primary objectives are to create an awareness of potential transfer-pricing issues related to international expansion, point out the implications that yesterday's decisions may have tomorrow, and focus on the opportunities that transfer pricing presents to the owner-manager. Our secondary objective is to reinforce the importance to all businesses, including owner-managed businesses, of preparing proper transfer-pricing documentation on a contemporaneous basis - as the information becomes available - rather than when a government auditor demands the information three or more years after the fact.

Each transaction, or potential transaction, is laced with issues from both a tax and business perspective. As each transaction presents its own unique challenges, no list or comment could ever be complete, nor is it professed to be. Our paper focuses on transfer-pricing determinations and transfer-pricing issues. It is beyond the scope of this paper to identify issues related to, for example, withholding, customs duty, or value-added taxes, and lack of mention should not be interpreted as lack of relevance.

After a brief overview of the context in which transfer pricing has evolved, including highlights of the guidelines established by the Organisation for Economic Co-operation and Development (OECD) and the new Canadian transfer-pricing legislation, the discussion of potential transfer-pricing issues and planning opportunities will address five specific stages of international expansion.

What seemed unthinkable 15 or 20 years ago is now a reality. In some respects, the world is becoming a single market with businesses from around the world competing for the same projects, no matter their geographic location. Businesses are constantly expanding into new territories. Competition takes place at the world level and not at the local level. It is within this context that transfer pricing is constantly evolving.

Government and business are each trying to keep pace with this rapid evolution. Each has different, if not conflicting, objectives and different levels of resources available. Understanding those objectives may help to highlight how they can impede or create tax-planning opportunities in the future.

Maximizing the return to shareholder investors is a core objective of commercial enterprises. The management of expenses, including global tax burden, is one factor in the profit maximization equation. Business decisions on the deployment of resources, coupled with corporate pricing policies, affect the level of profits to be taxed in a specific country. In this regard, the geographic distribution of profits earned by a multinational group may pose a threat to governments who may perceive overt challenges to their tax bases.

Governments and their tax regimes, aware of these threats, are constantly trying to keep pace. Some governments are responding through changes in their tax legislation to preserve their tax bases or compete for global business.

1) Protect the tax base. In order to preserve their tax bases, many tax regimes around the world have increased their scrutiny of related-party transactions and significantly increased the level of documentation required by members of a related group. Failing to maintain this documentation can result in significant penalties. Canada is included in this group (please see endnote 1).

2) Compete directly for business. Other tax regimes are introducing tax legislation to "attract" or "compete for" global business by offering tax grants, tax incentives, tax holidays, or combinations (please see endnote 2).

Introducing and enacting, or amending, transfer-pricing legislation aimed at protecting a country's tax base is the first step. Fundamentals, including contemporaneous documentation requirements and costly penalty provisions, are now staples when developing or refining tax legislation related to transfer pricing. Tax regimes that do not include these fundamentals in their income tax legislation may find themselves without the substance, the needed "hammer" to administer their tax systems, frustrate overt profit diversion, and compete with the tax regimes of other countries.

Over the years, OECD has released guidelines (please see endnote 3) that include general guidance for member tax administrations to take into account when developing documentation requirements (please see endnote 4) and penalty provisions (please see endnote 5) in their respective jurisdictions. Most member countries, including Australia, Canada, France, Mexico, South Korea, the United States, and the United Kingdom, have transfer-pricing legislation that includes these fundamental components.

Once transfer-pricing legislation is in place, a government may choose to focus its tax resources on ensuring that the appropriate amount of tax is paid. Publicity that may accompany this refocusing of resources and increased audit activity may contribute to increased awareness on both the national and international level. These actions will also reinforce the reality among MNE businesses that they must consider their potential exposure to transfer-pricing adjustments around the world and proactively address these issues. Transfer pricing is an international issue, requiring international coordination.

Let's look at the typical owner-manager: the individual is perhaps an engineer, a scientist, or a software designer, possibly someone who developed a product and cultivated its demand. First and foremost, however, the individual is an entrepreneur and business person accustomed to making things happen.

A judicious and deliberated decision to enter an international market may never be the reality; rather, the expansion step may just happen when an opportunity presents itself. The demands on the entrepreneur's time and energies when setting up operations or a business abroad are many. The owner-manager may need to:

• define the product for sale, evaluate the potential market demand for that product, and establish market penetration strategies;
• prepare sales and income forecasts, as well as profit projections;
• evaluate the stability, or instability, of each level of government in the foreign location and negotiate with each of those levels to obtain necessary regulatory and operating approvals;
• determine the potential issues related to the language spoken in the foreign location and the potential translation issues;
• consider other potential tax- and business-related issues, including the legal aspects of international expansion;
• establish local contacts and operations; and
• address warehousing and delivery logistics.

In short, an owner-manager is busy. It is quite possible, perhaps even likely, that transfer-pricing policies and documentation are not high on the priority list. However, they should be.

The potential transfer-pricing issues and opportunities should be considered at the outset and throughout the various stages of international expansion. Supporting documentation must be accumulated during this process, just as arm's-length parties would negotiate and document their arrangements. Transfer pricing is not limited to product costing. It includes pricing for tangible goods purchased (such as raw materials, finished goods, and capital assets), pricing for services rendered (such as administrative, technical, sales, marketing, engineering, and finance) and for the use of other intangible assets (such as technology and production knowhow, trade names, and trademarks). Today's decisions, no matter what is transferred between related parties, set the groundwork for the future placement of profit and payment of tax. Ultimately, this affects future bottom-line results.

The overall tax liability related to operations both in Canada and abroad is a significant cost of carrying on business that could make or break the investment decision, if not properly addressed. The risks associated with the lack of transfer-pricing documentation include increased local corporate tax liability, penalties and interest, potential double taxation, uncertainty as to the group's worldwide tax burden, and poor relations with local tax authorities.

• The OECD, based in Paris, was established in 1961 to set policies in order to:
• achieve the highest maintainable economic growth and employment and a sustainably rising standard of living in member countries;
• result in sound economic expansion; and
• contribute to the expansion of world trade through a multilateral, non-discriminatory basis (please see endnote 6).

There are currently 29 OECD-member countries (please see endnote 7).

Concern from the OECD on transfer-pricing matters was first communicated in the 1979 publication of a report on transfer pricing (please see endnote 8). It was determined then that guidance was needed on transfer-pricing issues to avoid any damaging effects that double taxation could have on international trade owing to the various tax principles adopted by member countries. The international standard that OECD-member countries have agreed upon for determining transfer prices for tax purposes is the arm's-length principle (please see endnote 9). The 1979 OECD report contained a series of guidelines aimed at determining acceptable transfer prices for tax purposes. The OECD issued two additional reports on related issues, one in 1984 (please see endnote 10) and another in 1987 (please see endnote 11).

The 1979 OECD report was revised in 1995 and in 1996 with the release of more comprehensive and detailed transfer-pricing guidelines including a glossary of terms. The OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations covers the following topics:

Chapter I: the arm's-length principle,

Chapter II: traditional transaction methods,

Chapter III: other methods,

Chapter IV: administrative approaches to avoiding and resolving transfer-pricing disputes,

Chapter V: documentation,

Chapter VI: special considerations for intangible property,

Chapter VII: special considerations for intragroup services, and

Chapter VIII: cost contribution arrangements.

The OECD guidelines on transfer pricing attempt to minimize the risk of double taxation and to encourage an international consensus on the determination of transfer prices. They address transactions among members of a MNE group, which by definition is a group of associated companies with establishments in two or more countries (please see endnote 12). Canadian small- or medium-sized businesses or owner-managed businesses operating outside Canada are covered by the definition and are not treated differently than large MNEs.

The OECD guidelines are exactly that: guidelines. Although they have no legal force in Canada per se, they are relied upon as an authoritative source of interpretation of the provisions of our domestic tax law dealing with transfer pricing (please see endnote 13). Revenue Canada has consistently endorsed the principles enunciated by the OECD, both in the 1979 OECD report (please see endnote 14) and in the OECD guidelines (please see endnote 15). Similarly, the OECD guidelines have been the impetus and basis for the transfer-pricing legislation of other member countries.

Under the arm's-length principle, related taxpayers should determine the price for intercompany transactions as if they were unrelated parties, with all other aspects of the relationship unchanged. The OECD guidelines acknowledge that it is often difficult to apply the arm's-length principle because of insufficient reliable information. Generally, two transactions need not be identical to be considered comparable, but they must be sufficiently similar to provide a reliable basis for determining an arm's-length price or allocation. The general comparability factors identified by the OECD guidelines that should be considered when assessing the comparability of transactions include:

• the specific characteristics of the property or services;
• the functions that each enterprise performs, including the assets used and, most importantly, the risks undertaken;
• the contractual terms;
• the economic circumstances of different markets - for example, different countries, wholesale versus retail; and
• the business strategies - for example, market-penetration schemes when a price is temporarily lowered (please see endnote 16).

The OECD accepted transfer-pricing methods have been divided into two groups: the traditional transaction methods (which include comparable uncontrolled price, resale price, and cost-plus) and the transactional profit methods (which include profit-split and transactional net margin method). The OECD guidelines, recognizing the burden that testing multiple methods would place on both the taxpayer and the tax administrations, does not require detailed analyses under more than one method. A taxpayer should, where possible, select the method that provides the best estimation of an arm's-length price (please see endnote 17). The OECD prefers the traditional transaction methods over transactional profit methods or other methods (such as global formulary apportionment) (please see endnote 18). Ultimately, the selection of a transfer-pricing method depends on the reliability of the data available and the circumstances of the particular transaction.

The OECD guidelines define the recognized methods as follows:

On June 18, 1998, Canada enacted new transfer-pricing legislation (please see endnote 20). In general terms, the Canadian transfer-pricing legislation requires a Canadian taxpayer to make reasonable efforts to determine and use arm's-length transfer prices and/or allocations when transacting with a related non-resident person (please see endnote 21). Failure to do so may result in an adjustment of an income or capital nature, a reassessment of taxes payable, non-deductible interest charges, and the imposition of a penalty. The potential exposure of a Canadian company to an adjustment in the determination of taxable income or loss as previously filed, or an adjustment to the capital property or eligible capital property account balances, is not new. It is part of the routine audit exposure. Contemporaneous documentation maintained by prudent management to support all material business transactions can facilitate an audit defence; it cannot eliminate the taxpayer's exposure to the possibility of adjustment on audit.

The exposure to penalty is new. Canadian taxpayers may be liable for a penalty (please see endnote 22) of 10 percent of the income and capital adjustments if the transfer-pricing income and capital adjustments exceed a penalty threshold (please see endnote 23) and the taxpayer has not made reasonable efforts to determine and use arm's-length prices. Reasonable efforts are defined in subsection 247(4) of the Act to include specific information that must be provided on a contemporaneous basis including a description (please see endnote 24) of:

i) the property or services to which the transaction relates,

ii) the terms and conditions of the transaction and their relationship, if any, to the terms and conditions of each other transaction entered into between the participants in the transaction,

iii) the identity of the participants in the transaction and their relationship to each other at the time the transaction was entered into,

iv) the functions performed, the property used or contributed and the risks assumed, in respect of the transaction, by the participants in the transaction,

v) the data and methods considered and the analysis performed to determine the transfer prices or the allocations of profits or losses or contributions to costs, as the case may be, in respect of the transaction, and

vi) the assumptions, strategies and policies, if any, that influenced the determination of the transfer prices or the allocations of profits or losses or contributions to costs, as the case may be, in respect of the transaction.

Therefore, it should be understood that the provision of contemporaneous documentation in accordance with subsection 247(4) of the Act is a measure to manage a taxpayer's exposure to penalties. However, the discipline of preparing documentation should also provide rewards to the taxpayer in facilitating timely response on tax authority audit, whether or not the penalty provisions are effective. Although in the normal course of an audit for earlier years it may not be appropriate for Revenue Canada field auditors to expect, or otherwise request, contemporaneous documentation at the standards legislated for periods beginning after 1998, taxpayers must be in a position to support their related-party transactions for earlier years as well.

Revenue Canada's views on transfer pricing are set out in a draft Information Circular 87-2R (draft IC 87-2R) that was released on September 11, 1997. Revenue Canada is expected to finalize IC 87-2R in early 1999 [actually released on September 27, 1999]. As mentioned earlier, Revenue Canada closely follows the OECD guidelines.

International expansion can take many different forms, include many different stages, and occur over significantly different time horizons. Every situation is unique, and each fact pattern will present different, albeit similar, transfer-pricing issues and tax-planning opportunities. This paper defines and addresses five specific and not uncommon stages of international expansion:

• using an arm's-length seller in the foreign location,
• initiating branch operations to sell in the foreign location,
• incorporating a distribution entity in the foreign location,
• establishing manufacturing operations in the foreign location, and
• operating a "self-sustaining" operation in the foreign location.

The potential transfer-pricing issues and planning opportunities at each of these five stages of international expansion will be discussed in the context of a hypothetical, though common, situation.

Absolutely the Best Club Ltd. (ABC) is a Canadian-controlled private corporation, managed by its founding and only shareholder, Albets Cashin. Several years ago, Albets developed a unique metal compound that could be used as a raw material in the production of golf clubs. This unique metal compound allows ABC to manufacture a lighter weight and stronger club head that provides a golfer with greater accuracy and distance than does ABC's competition. Albets incorporated his invention to form ABC, which subsequently developed the molds, the machinery used to inject the unique metal compound into the molds, and the manufacturing process used to produce the golf clubs. ABC owns all of the intangible assets related to the business, including the worldwide patents, trademarks, and production knowhow.

In the past, ABC has focused its sales and marketing efforts in Canada; however, its product is now being demanded worldwide, especially in the United States. Sales have grown exponentially over the past year in a marketplace that is extremely competitive. Therefore, ABC has decided to formally enter the US market; expansion into other international markets will not occur for several years. Albets has run an efficient operation, focusing on production and marketing, both of which were compatible with his engineering background and love of the game of golf. Financial and administrative resources within ABC are limited, and in Albets's view will stay that way.

Stage 1: Using an Arm's-Length Seller

Given ABC's scarce financial resources, the first stage of international expansion will be confined to engaging a third-party seller situated in the United States to market and sell ABC-branded golf clubs. Both an independent sales agent and an arm's-length distribution company were considered. The issues are somewhat similar, but in order to mitigate some of the concerns with respect to us tax exposure, ABC chose to sell through a third-party distribution company. We have assumed that no permanent establishment of ABC has been created for us income tax purposes, that the third-party seller is not restricted to selling just ABC's product line, and that ABC will price the golf clubs to the third-party seller at a discount from the suggested retail price. Albets insists on referring to this as the third-party seller's commission.

If we assume that ABC has no taxable presence or permanent establishment in the United States, then there are no transfer-pricing issues to address, at least none at this time. There may be us state tax implications; however, we will not be addressing these issues. The importance of discussing this first stage of international expansion is to highlight the possible implications to and opportunities for the future transfer-pricing structure as ABC expands and performs additional functions and assumes additional risks outside Canada. We are planning now to ensure opportunities in the long term are maximized.

We expect that the arrangement entered into between ABC and the third-party seller will be committed to writing in a legal agreement that defines the terms and conditions of the arrangement. Some such terms and conditions are set out below.

1) a definition of the territory or geographic region within which the third-party seller may sell;

2) exclusivity provisions, if any, outlining who can, and cannot, sell ABC golf clubs in the defined territory;

3) pricing and other transaction terms, such as: a) discount rate from suggested retail price or commission rate based on net sales, b) volume discounts, c) minimum purchase commitments, d) timing and location of transfer of title to goods, e) returns policy, f) currency in which the transaction is to be denominated (Canadian or US dollars), g) payment or credit terms, and h) warranty responsibilities;

4) marketing and advertising responsibilities or shared promotion arrangements;

5) the term for which the agreement is applicable; and

6) termination terms.

Formalizing the agreement in writing with the third-party seller and documenting the responsibilities of each party is a critical step in avoiding misunderstandings or disagreements throughout the duration of the relationship. The terms of this agreement between ABC and the third-party seller constitute arm's-length arrangements.

As we discuss the other four stages of international expansion, we will come back to this stage to reinforce how the arrangements entered into at the outset may affect future transfer-pricing decisions and options.

In summary, this first stage of international expansion does not by itself create any immediate Canadian transfer-pricing issues. The relationship between ABC and the third-party seller is at arm's length; therefore, so are the terms and conditions for those arrangements. This stage may form the foundation of future transfer-pricing policies and the documentation that is prepared at this point must be weighed with a long-term view. Maintaining flexibility is an important objective and must be fully considered.

Stage 2: Initiation of Branch Operations

The next stage of international expansion may be the initiation of branch operations. ABC begins to assume and perform limited sales and marketing activities in the United States, rather than only selling through the third-party seller arrangement established in stage 1. The branch may employ a sales force that is dedicated to selling and marketing ABC golf clubs in the US marketplace. At this time, ABC has decided not to incorporate a separate legal entity in the United States; however, we will assume that a permanent establishment will be created. The branch operation will only perform sales functions and it will not be responsible for managing any significant risks at this stage of expansion.

ABC will be required to file a US income tax return and pay taxes on US branch profits. Therefore, ABC will need financial statements for the US branch operations. Both US domestic legislation and the provisions of the Canada-US income tax convention (the treaty) must be considered in calculating taxable income earned by the branch for US income tax purposes. Generally, the United States should only be allowed to tax business profits that would reasonably be expected to have accrued had the branch activities been conducted by a separate and independent legal entity (please see endnote 25).

For Canadian income tax purposes, ABC will also be taxable on the profits earned by the US branch operations and may be entitled to relief for US taxes paid through the Canadian foreign tax credit mechanism (please see endnote 26). The transfer-pricing rules in section 247 of the Act do not apply to transactions between a branch operation and its "home office." (please see endnote 27) Consequently, similar to stage 1, there are no immediate Canadian transfer-pricing issues at this stage of international expansion. However, transfer-pricing arm's-length principles may be looked to for guidance in the determination of business profits attributable to the branch in accordance with article VII of the Canada-US treaty, as well as for foreign tax credit purposes.

The challenge to ABC at this stage of expansion, to ensure that it is not double taxed on the US branch profits, is to ensure that it can defend the branch profit determination. ABC must comply with tax legislation enacted by two different tax regimes. Each has different rules, documentation requirements, interpretations, and administrative policies with respect to transfer pricing. Although obvious, these differences are often ignored by those expanding globally. Compliance in one country does not ensure compliance in another. Although most countries generally follow the OECD guidelines, differences in interpretations and administration do exist (please see endnote 28).

Before making a decision to replace the third-party seller arrangement or commence selling into a foreign market through a branch, ABC may have prepared financial projections or forecasts and accumulated other information to assist it in making its investment decision. This information should be retained as part of the documentation of assumptions, strategies, and policies to support the income calculation of the branch. The terms, conditions, and contractual arrangements outlined in the agreement entered into with the third-party seller in stage 1 should be compared with the facts surrounding the branch operations to determine whether the income allocated to the branch is reasonable for US tax purposes. Differences in the third-party arrangements could exist as a result of the functions performed and risks assumed by the branch. Documentation of these differences and similarities will avoid confusion in future years when reviewing pricing arrangements.

In summary, although there are no direct Canadian transfer-pricing issues in relation to the branch operations, the principles of transfer pricing may be useful in determining the business profits attributable to the branch.

Stage 3: Incorporation of a Distribution Entity in the United States

ABC will incorporate a wholly owned subsidiary (Subco) in the United States that will purchase and sell ABC golf clubs in the US marketplace during the third stage of international expansion. Subco will rely on ABC to provide most of its general and administrative services, including all accounting, ordering, payroll, payable, and receivable functions. Subco will perform mainly distribution, sales, and limited marketing activities. Subco will assume limited inventory and accounts receivable risks.

As Subco and ABC are related (please see endnote 29) corporations, they do not deal at arm's length (please see endnote 30). The US and Canadian transfer-pricing legislation will apply to the transactions between the entities (please see endnote 31). Consequently, at this stage it will be important to identify the transfer-pricing issues arising and to ensure that the appropriate policies are established and implemented. The transactions entered into previously may impact the determination of the current policies.

Two specific transfer-pricing issues to consider at this stage of international expansion are:

1) determining the product transfer price for golf clubs sold by ABC to Subco and

2) determining the transfer price, or charge, for services provided by ABC to Subco.

Maintaining supporting documentation for the transactions is not an isolated issue. The adequacy of documentation should be addressed as each transfer price or policy is determined.

At this phase of international expansion past policies may affect today's decisions. The agreement entered into with the third-party seller may assist in determining, for better or worse, the transfer-pricing policies that should be employed between ABC and Subco.

For Canadian income tax purposes, we must first consider if a comparable uncontrolled price (CUP) exists to determine an arm's-length price to use for the sale of golf clubs from ABC to Subco. ABC's past relationships with the third-party seller, and the written agreements, may form the basis for determining that transfer price. Ultimately, the premise that we should start from is that the price paid by the third-party seller for the ABC golf clubs will be "similar" to that paid by Subco for the same golf clubs. Obviously, in order for the prices to be similar, so must be the surrounding facts and circumstances. Ideally, if the third-party agreement price represents a CUP under similar facts and circumstances, it can be used to determine and support the transfer prices used for the sale of product between ABC and Subco.

For this reason, it was important to consider the long-term objectives of ABC when entering into the third-party agreement. If the terms and conditions of the third-party seller arrangement are similar to those of the Subco arrangement, the transfer price should also be similar. Fully documenting the terms and conditions agreed to by ABC and the third-party seller would better enable us either to use the CUP as an arm's-length price or to identify why the potential CUP is not appropriate to use. It is difficult, if not impossible, to go back in time to when the agreement with the third-party seller was signed and determine the specific conditions or circumstances surrounding the agreement. Those who made the decisions and entered into the agreements may not remember the conditions and circumstances or may no longer be with the company to answer those questions.

When comparing the arrangements with the third-party seller to those with Subco, it is likely that the facts, circumstances, or terms and conditions have changed. If so, adjustments will have to be made to arrive at Subco's transfer prices. It may be that adjusting the transfer price for these differences is impossible and unsupportable. For example, consider the matters set out below.

1) Different functions. The subsidiary may be required to maintain and warehouse an inventory of golf clubs, with a view to managing the supply among seasonal and non-seasonal markets to ensure that the maximum market price is achieved. On the other hand, the third-party seller may have only ordered ABC golf clubs to fill a specific customer order and requested that ABC ship the golf clubs directly to the customer. Therefore, the third-party seller neither carried nor warehoused inventory and did not perform the distribution function. The price charged by ABC for the golf club should differ in this situation.

2) Different risks. The placement of risks under the arrangement with Subco may differ from the arrangement with the third-party seller. If ABC, to avoid discounting the price of clubs on hand at the end of the golf season, accepted returns from the third-party seller and did not adopt the same policy with Subco, then Subco has more inventory risk. Where the risks vary, it is appropriate that the transfer price of the product also differs to reflect the different level of risk.

3) Changing market conditions. The selling price to customers may have changed over time because of acceptance of the ABC golf club in the market or because of the introduction of new competitive products. Hence, the overall profitability of the product line will have changed and the circumstances are no longer similar enough to support a CUP.

4) Market-penetration strategies. Since the third-party seller was engaged at the time of the initial product launch into the United States, throughout the third-party seller arrangement ABC may have incurred significant marketing and promotion costs to establish awareness and promote the ABC golf club within the US marketplace. In this situation, if the third-party seller was expected to incur limited marketing and promotion costs and the US market-penetration costs were borne by ABC, the marketing intangible would normally belong to ABC. Alternatively, ABC may have offered sales incentives to the third-party seller through pricing discounts based on volumes sold or otherwise in order to encourage the third-party seller to meet sales targets. This may have been done because ABC could not control the everyday activities of the third-party seller regardless of the level of marketing and promotion expenditures made by ABC. ABC may now plan to reduce its marketing and promotion efforts in the United States, these activities becoming the responsibility of Subco. The facts are different. ABC's direct marketing and promotion costs may be reduced, while those incurred by Subco may be greater than expected of the third-party seller. The transfer price should differ. The amount of the difference will depend on the specific facts and circumstances.

5) Other potential adjustments. Other possible areas where Subco may be distinguished from the third-party seller in such a way as to warrant an adjustment to the transfer price of the golf clubs may include, but are not limited to, the items set out below.

a) the inclusion of landing costs such as freight, insurance, duties, and other similar costs in the sales price;

b) the payment terms and discount program;

c) the stage in the product's life cycle (such as startup, growth, maturity, decline, or termination);

d) access to the customer list;

e) the currency in which the product is sold and the assumption of the related foreign exchange risk; and

f) the reimbursement of costs related to various services or related functions pursuant to a cost-sharing arrangement.

Sometimes these and other differences, such as adjustments for marketing intangibles, cannot be quantified owing to the assumptions required. The number of adjustments, and assumptions required for each, will dictate the reliability of any potential CUP

The manner in which Subco is established could also be relevant to the transfer-price question. What if ABC bought out the third-party seller rather than establishing a new subsidiary?

1) If the purchase price paid by ABC for the shares of the third-party seller includes only a nominal amount for goodwill, (please see endnote 32) then the transfer-price arrangements under the existing agreement should be adjusted for changes in the way that ABC decides Subco should do business in the future.

2) If the purchase price paid by ABC for the shares of the third-party seller includes a premium (please see endnote 33) in recognition of the developed market, the established customer base in the territory, or the trained sales staff or technical sales support, then the third-party seller may have owned a market intangible of value to ABC.

3) If ABC first acquires the business assets of the third-party seller and then assigns the territory to a newly formed subsidiary corporation and contributes the tangible business assets to that subsidiary, the future pricing to the subsidiary may be less favourable than the previous arm's-length pricing to the third-party seller if ABC retains a market intangible.

4) If the acquisition of business assets from the third-party seller was made by the new subsidiary itself, the prior arrangement should be examined to determine if the price is comparable. That is, the pricing to the subsidiary, when compared with that to the third-party seller, should not be adjusted in respect of the market intangibles acquired by Subco from the third-party seller.

These are just a few of the possible adjustments or considerations that could be relevant in assessing whether the arrangements with the third-party seller could be used as a CUP. Are there other sources for a CUP? It is unlikely that Subco, a newly established subsidiary, will be distributing a product for other suppliers. However, if ABC bought out a former third-party distributor that sold non-ABC products, there may be other arm's-length information that could be used.

If there is no CUP, if it is too difficult to make the appropriate adjustments, or if the adjustments are too substantial to provide a meaningful comparison, a different transfer-pricing methodology should be considered. As a next step, one might review the third-party seller transaction to see if it establishes a comparable permitting the appropriate application of the resale price method. One would also consider ABC's sales approach for the Canadian market to see if there is any helpful information. If necessary, the transactional net margin method (TNMM) could be considered.

ABC will also provide general and administrative services for Subco. Therefore, it is necessary to determine for which, if any, of those services Subco should be charged. The decision to charge separately for certain services may impact the transfer price of the golf clubs.

Administrative services of the nature described in the example (accounting, ordering, payroll, payable, and receivable functions) are most commonly charged as an allocation of the costs of providing the service based on a reasonable sharing formula. It should be clear that the service has been performed for the benefit of Subco and that the expense is not for the sole benefit of ABC (please see endnote 34).

Is a markup appropriate? The possibility of applying a markup is an area of changing attitudes (please see endnote 35). The arm's-length concept focuses on value, not cost. If the value of the services is greater that the related cost, then a markup could be considered. For example, what would Subco pay to a third party to perform the same tasks? The functions in the example are not typically regarded as value-added, but ABC would, at least, want to demonstrate that the value of the services is at least equal to the costs charged. From a business-strategy perspective, ABC may have estimated the cost to Subco to establish an office in the United States and staff it to perform the administrative tasks locally. This would be useful information to retain as support of value.

Generally, if functions performed by ABC on behalf of Subco are performed for efficiency of centralized services but are with respect to functions for which Subco is required to bear the costs under the distribution arrangement, they should be charged separately from the transfer price of the golf clubs. On the other hand, if ABC chooses to perform certain functions itself rather than make them the responsibility of Subco, then compensation for those functions or services should be included in the determination of the transfer price.

This can be illustrated by way of an example. ABC brand recognition was created by ABC and ABC may continue to direct the creative brand marketing. The design work for all promotional material could be centrally created and produced by ABC. If Subco's limited marketing responsibilities include holding demonstrations at various US golf clubs or tournaments throughout the season, it may be charged the related costs of printing US literature, building portable display booths, or producing banners or signage used in sponsoring tournaments. Subco would not pay for the creative design work, nor would it be entitled to participate in the premium return for the brand intangible. However, if Subco is responsible for all US marketing activity, then it may also be expected to bear (please see endnote 36) or share the creative costs. An allocation of costs might be based on the volume of brochures used in each market, the number of minutes of advertising placed, the number of tournaments sponsored, or some other measure that reflects a reasonable sharing of costs in proportion to benefits derived by each of Subco and ABC. In this situation, the transfer price to Subco would be reduced to reflect its assumption of marketing functions and risks. However, if ABC continued to bear all marketing costs, the transfer price of the golf clubs would be higher and ABC would retain the resulting profit potential.

Arm's-length parties submit invoices for services rendered on a regular basis, perhaps monthly, and provide detailed support for the charges. Detailed support might include a description of the services provided or a statement of the number of hours spent or the number of transactions processed or the number of brochures printed with additional details on the nature of the services provided. Related parties should conduct their affairs in the same manner. Timely invoicing with adequate disclosure is critical in mirroring arm's-length transactions.

The deductibility, under US legislation, of specific expenses to be charged or costs to be allocated to Subco must also be considered. For example, meals and entertainment expenses are not fully deductible in Canada or in the United States. Therefore, it is possible that a portion of the shared costs allocated to Subco could also be non-deductible for income tax purposes.

The topic of intragroup services is much more extensive than that set out in the ABC fact pattern. Other examples of intragroup services and the potential implications on transfer prices are described below:

1) Research and development (R & D). R & D can be defined as a cost incurred in the hope of developing an intangible asset that will produce benefits in future years. R & D efforts can relate to the advancement of both products and processes.

If a portion of the R & D costs related to developing products are borne by Subco, then Subco should be in a position to share in any future rewards. It will be necessary to determine how future profits attributable to the product improvements or enhancements resulting from the R & D activities will be shared between ABC and Subco. Subco's participation in R & D funding would also affect the future transfer price for the products supplied by ABC to Subco. If Subco shared in the R & D cost of a new product and that product is later sold by Subco to the US market, then Subco should be entitled to a portion of the profit related to the product intangible.

It is possible that the new product incorporates or builds on previous knowledge or an existing technology whose development was fully funded by ABC. One must consider how to differentiate past R & D efforts for which Subco did not share the R & D costs. Unless current product developments are separate and identifiable, this may be impossible to accomplish and may add an unwanted level of complexity to the arrangement. Alternatively, the past R & D efforts could be valued and the option of Subco's "buying in" could be explored (please see endnote 37)

Similarly, if Subco shared in the cost of developing the manufacturing process, then Subco should participate in the benefits derived from the manufacturing knowhow through a lower product transfer price.

2) Marketing services. If Subco is not taking title to the golf clubs but only providing selling and marketing services or assistance, a cost-plus approach to pricing of services provided or functions performed might be considered. This approach provides a return on operating expenses. The transfer-pricing question is the determination of the appropriate "plus." A search of public databases for companies performing similar functions (that is, sales and marketing) with limited capital and no inventory could be a source of guidance.

The charges for intragroup services should be established from the outset. Documentation of the policy, and the regular issuance of detailed invoices in accordance with the policy should address the contemporaneous documentation requirements as well as define the duties and responsibilities of specific staff in each operation.

In summary, ABC will be required to maintain contemporaneous documentation to support the pricing on transactions with Subco. The previous arrangement with the third-party seller should be carefully considered and compared when determining the prices. If Subco is performing similar functions and assuming similar risks, the income derived would also be expected to be similar.

Subco's sales have grown substantially and ABC has decided that Subco will begin manufacturing golf clubs in the United States using ABC's proprietary manufacturing knowhow. Subco will purchase the capital assets required for use in the manufacturing process from ABC and source its raw material requirements from ABC's qualified suppliers. To a lesser extent, ABC will continue to perform administrative services on behalf of Subco. Finally, perhaps Subco will begin to sell some of its production to ABC. In summary, Subco will perform manufacturing and additional administrative functions and assume the related warranty and manufacturing risks.

At this stage of international expansion, we have identified five potential transactions to consider.

1) the purchase of capital assets by Subco from ABC,

2) the use of ABC's proprietary manufacturing knowhow by Subco,

3) the purchase of raw materials by Subco,

4) the sale of golf clubs by Subco to ABC, and

5) the provision of services by ABC to Subco.

Related parties may often transfer capital assets within the related group at the landed/invoiced cost for new equipment and at net book value for used equipment. Although these policies may be simple to apply, they may not be reflective of arm's-length arrangements and may have undesired implications. Practically, one may want to consider the transaction's materiality to determine the depth of analyses needed. Consider the following transactions with respect to the acquisition, or use of, capital assets.

1) Subco purchases "new" equipment from ABC. Assume that the equipment sold by ABC to Subco is "new" and was purchased from an arm's-length party. If Subco could purchase the equipment directly from the arm's-length party at the same price and under the same terms and conditions, then a transfer price equal to the invoiced cost is likely appropriate. However, there may be several reasons why the purchase price should be a different amount.

a) Is Subco charged an intragroup service fee that includes an allocation for the purchasing department's assistance? ABC will have incurred costs related to the purchase of the equipment. This could include personnel time to find the appropriate equipment, qualify the supplier, negotiate the purchase agreement, maintain supplier relations, and secure delivery of the equipment. Subco would have incurred similar costs if it had sourced the equipment independently. Therefore, a sourcing charge may be appropriate. This may depend on whether Subco is already charged for the purchasing department's time and efforts, via an intragroup service fee or otherwise. If it is, then no further costs should be allocated to Subco. If not, it may be appropriate to adjust the transfer price of the equipment accordingly.

b) Is the equipment proprietary in nature? If the equipment has been developed by ABC or contains certain proprietary enhancements that Subco could not otherwise obtain independently, then it may be appropriate to adjust the transfer price, unless Subco shared in the development costs related to the equipment. If a charge for the enhancements is appropriate, it could be in the form of a royalty or the equipment price might reflect the value of enhancements embedded in the equipment. In either case, ABC would be compensated for the use of the proprietary enhancements.

2) Subco purchases equipment that was previously used by ABC. Net book value may not necessarily represent an arm's-length price but the determination of market value may be difficult perhaps because of the customized nature of the machinery. Furthermore, it is unlikely that ABC would sell equipment incorporating proprietary technology to a competitor. Issues similar to those above are also relevant. Consider if a transfer price based on the actual production in the future has merit. The point is that flexibility in establishing the price may exist. The objective is to determine and document an arm's-length price.

3) ABC retains ownership of the equipment. ABC may wish to retain the ownership rights to the equipment and charge Subco for the right to use the equipment - an arrangement akin to rent or a royalty. This may not be a desirable alternative if it creates US tax issues related to permanent establishments and withholding taxes. Where ABC wants the ownership of the proprietary enhancements or any intangible assets to reside requires serious deliberation. The decision may be critical in maximizing long-term opportunity and minimizing the global tax burden.

If ABC improved the equipment, Subco should be charged the appropriate fair market value. Decisions reached, the valuations completed, and the methods used to determine the transfer prices should be documented and maintained by both Subco and ABC.

The purchase of the capital assets may not be all that Subco needs in order to be in a position to commence manufacturing operations. Subco will require the product formulation and may also require specific knowledge on how to produce the golf clubs.

1) ABC owns the rights to the secret formula blend of metals in the golf club and, in this case, that formula is valuable. Arm's-length parties could not otherwise use the formula and, accordingly, Subco should be charged an amount for its use.

2) An understanding of the production process, or knowhow, is also required. This may be communicated via a production manual containing information on, for example, the appropriate gage settings for the efficient use of the equipment, the speed at which the machine should be run, the optimal compression level, or other technical information. Determining whether to charge Subco for the use of knowhow may depend upon whether Subco could easily and quickly develop the knowledge on its own without significant expense.

The charge for both of the above (collectively referred to as "knowhow") could take the form of a royalty. In order to take advantage of the Canada-US treaty exemption from withholding tax on royalties for the use of knowhow, (please see endnote 38) and simplify issues related to the unbundling of royalties, the payment for production knowhow should be separate from any payment for the use of marketing-type intangibles (such as trade names).

Alternatively, Subco might purchase the knowhow, or an interest in it, at an arm's-length purchase price. However, it may not be prudent for the subsidiary to purchase the knowhow outright. The income on future sales arising from past and future product and/or process developments may then accrue to Subco. In addition, this could also have a significant impact on cash flows, given that ABC would have to fund the tax liability resulting from the disposition. Furthermore, if Subco purchases an interest in the knowhow and if ABC continues to perform the R & D, Subco should share in the R & D costs in order to maintain its proportionate interest. On the other hand, there may be a planning opportunity if the rights to the knowhow could be held by an ABC group company situated in a jurisdiction with a low tax rate.

The implications of prior-year decisions will again affect the determination of the transfer-pricing policy. If Subco had shared in the cost of developing the manufacturing knowhow or product formulation from the outset, and if Subco already had the right to use the information, there may be no basis for a charge.

Finally, if Subco makes process improvements, the question arises as to who will bear the cost. If ABC does not fund the cost of these advancements or improvements, and they prove to be valuable, then Subco may have to charge ABC a royalty in the future!

Many businesses simply charge foreign affiliated companies for the actual cost of the raw materials purchased from third parties on their behalf or have the third party invoice the subsidiary directly. There are transfer-pricing issues to consider in both of these situations.

One approach may be for ABC to charge Subco the actual cost of the raw materials plus a markup to cover the costs of the purchasing department and any warehousing. The markup could be based on budgeted purchase volumes and purchasing department costs. To test the reasonableness of the markup, the total amount of markup actually charged could be compared with the total costs of the purchasing department actually incurred to check that the costs recovered through the markup do not exceed a reasonable portion of the purchasing department's expenses.

A second approach would be for ABC to charge Subco the actual cost of raw materials and charge for the purchasing services through a intragroup charge or allocation of actual costs. The basis of the allocation is the key question. If based on the value of raw materials purchased, the amount would be similar to the first approach. If based on an estimate of time spent, the amount could be quite different. The other difference from the first approach is the classification of the expense as an inventory rather than an operating expense.

Volume discounts and rebates should also be considered. Did ABC receive a volume discount or rebate because of ABC's collective purchase power? If it did, the transfer-pricing issue that arises is whether Subco should share in any, or all, of the discount. If ABC negotiated the discount based on its total purchases with that supplier, and Subco would not have been able to negotiate a similar discount on its purchases alone, then an argument might be made that Subco should not share in the discount. Using the arm's-length principle, the transfer price might be the price that Subco would have otherwise negotiated - without the discount.

If Subco purchases the raw materials directly from the supplier, it will be important to consider if any rebate or discounts received by ABC as a result of the Subco purchases are allocated to the subsidiary. Any related documentation from the supplier should be retained.

It is also necessary to establish a transfer price for the products manufactured by Subco and sold to ABC. Here, past intercompany transfer-pricing policies (from stage 3) might appear to be the obvious place to start. But if ABC has retained an interest in all product and production intangibles, it should not be required to pay for these in the product purchase price. Similarly, Subco would not pay a royalty to ABC on products produced for ABC.

The transfer-pricing issues at this stage of international expansion are similar to those discussed in stage 3 above. The same considerations, concerns, and planning opportunities should be considered. It is important to remember that functions are continually being changed, transferred, and redefined. As the functions change, in nature or location, so must the transfer prices and intragroup charge. A regular periodic review is desirable to monitor the currency of policies.

We have discussed several transfer-pricing issues that may be encountered during this stage of international expansion. An alternative to placing any of these functions, risks, and rewards in Subco would be to make it a contract manufacturer. The concept of contract manufacturer is not defined in the OECD guidelines. The sole reference at paragraph 1.25 indicates that a contract manufacturer that takes on no meaningful risk would be entitled to a limited return. A contract manufacturer provides manufacturing services to a company. The placement of functions and risks of each contract-manufacturing arrangement will vary. For example, a contract manufacturer typically does not develop its own product lines and it might not perform such functions as material purchasing or production scheduling. Ultimately, by setting Subco up as a contract manufacturer, the transfer-pricing issues may be simplified.

In this example, Subco could be remunerated on a cost-plus basis or on a pre-established price per unit. If attempting to limit the risks, Subco would not own or pay for the use of intangible assets (such as proprietary equipment, production knowhow, or secret formulas) or purchase or own raw materials. As a low-risk contract manufacturer, Subco's profitability would be low.

Subco would manufacture the golf clubs under ABC's direction and for ABC's account. ABC might then sell the golf clubs to another related company for distribution. Subco would be compensated purely for the manufacturing function.

It is easy for owner-managers to focus on what they do best, develop a product and promote demand for that product. It is also easy for them to defer addressing the transfer-pricing issues. However, issues are many and should be recognized and dealt with at the outset with due regard to the impact of current decisions on tomorrow's ambitions.

In our final defined stage of international expansion, Subco will assume all manufacturing, marketing, sales, and distribution activities. The functions added during this stage of expansion will include R & D activities related to the product and the manufacturing process. Subco will also assume substantially all administrative functions and activities. The additional risks assumed by Subco at this stage of international expansion will relate to its R & D activities.

By the time ABC reaches this stage of international expansion, most of the transfer-pricing issues should have already been addressed. Those related to the distribution and manufacturing activities were addressed in stage 3 and 4 respectively. The main difference at stage 5 is that Subco will now be expected to participate in both performing and funding its own R & D.

In making the decision as to where to locate an R & D facility, ABC will have considered a number of factors, such as the availability of skilled resources and expertise, favourable tax credits or incentives offered by various jurisdictions, and the protection afforded to intangible rights. Once the decision has been made as to where to perform the R & D, issues such as funding, sharing of benefits, and ownership of results remain to be addressed.

As a general rule, parties that share in the risk of funding of R & D should be entitled to share in the rewards. This concept is covered by the OECD guidelines (please see endnote 39) and will not be covered herein.

It will be important to review prior transfer-pricing methodologies to determine whether the charge is still appropriate. For example, to the extent that intragroup services and marketing support are no longer being provided, the determination of the costs to be allocated and the base for allocation should be reviewed and modified appropriately.

At this point, it is apparent that decisions made in stage 1 of international expansion, and each stage thereafter, may very well affect the level of returns and ultimate profits recognized in stage 5. Indeed, by stage 5, the profile of ABC's US operations has changed dramatically. The company can be haunted by past decisions relating to the ownership of intangible property and the methodology used to transfer products and processes. Planning and foresight are vital because a government audit is certainly not the time critically to assess past pricing practices. Therefore owner-managers are cautioned to take action from the outset with regards to transfer pricing.

Transfer pricing is a worldwide issue that affects all companies both large and small. It is not restricted to the multinational conglomerate, but it is relevant to any company that is operating internationally. This discussion is intended to inform and reinforce the needs for accurate and timely transfer-pricing policies and practices.

Owner-managers are encouraged to maintain a clear, simple record of decisions and the allocations of functions, risks, and intangibles as they progress through each stage of expansion. This includes proper documentation that supports the related-party transactions and to a significant extent reflects decisions and approaches that "mirror" arm's-length relationships. Where there is a CUP (or close hybrid), the facts and circumstances should be documented. Intercompany agreements created on proactive and contemporaneous basis help support actions when employees may not be available later to explain or remember. Owner-managers should consider both the current and long-term impact of today's decisions on tomorrow's growth and profit potential.

Do today's decisions leave the door open to maximize global profits tomorrow?

* Written by Brenda J. Humphreys and Saul Planer and first published by the Canadian Tax Foundation in the 1998 Conference Report.

-Brenda J. Humphreys, CA. Partner, PricewaterhouseCoopers LLP, Mississauga. BA Business Administration (1977) University of Western Ontario; CA (1980) Institute of Chartered Accountants of Ontario. Founding member, Mississauga Revenue Canada/Tax Practitioners Group. Author and frequent speaker on transfer pricing.

-Saul Plener, CA. Senior manager, PricewaterhouseCoopers LLP, Mississauga. Bachelor of Business Administration (1986) York University; CA (1988) Institute for Chartered Accountants of Ontario. Former large-case-file auditor, Revenue Canada; speaker on transfer pricing issues in Canada.

ENDNOTES

1 On September 11, 1997, Canadian Finance Minister Paul Martin and Revenue Minister Herb Dhaliwal jointly released draft amendments to the Income Tax Act relating to transfer pricing, including the introduction of penalties. In addition, the revenue minister indicated that the proposed new provisions were consistent with Revenue Canada's intention to devote more resources to the verification of cross-border transactions by multinational enterprises. The transfer-pricing legislation passed into law on June 18, 1998 and the number of dedicated transfer-pricing group resources is reported to be increasing to 62 persons at headquarters in Ottawa.

2 PricewaterhouseCoopers, International Transfer Pricing 1998-99 (United Kingdom: CCH Editions Limited, 1998), at 309. Irish tax law provides for exemption from tax for "income from a qualifying patent."

3 Organisation for Economic Co-operation and Development, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Paris: OECD) (looseleaf) (herein referred to as "OECD guidelines" or "the guidelines"). Chapters I to V were released in July 1995, while chapters VI and VII were released in March 1996, and chapter VIII was released in August 1997.

4 Ibid., chapter V.

5 Ibid., chapter IV discusses penalties at paragraphs 4.18 through 4.28.

6 Supra footnote 2, at 22.

7 The original member countries of the OECD are Austria, Belgium, Canada, Denmark, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States. The following countries became members subsequently through accession: Japan, Finland, Australia, New Zealand, Mexico, the Czech Republic, Hungary, Poland, and the Republic of Korea.

8 Organisation for Economic Co-operation and Development, Transfer Pricing and Multinational Enterprises (Paris: OECD, 1979) (herein referred to as "the 1979 OECD report").

9 OECD guidelines, supra footnote 3, chapter I.

10 Organisation for Economic Co-operation and Development, Transfer Pricing and Multinational Enterprises: Three Taxation Issues (Paris: OECD, 1984).

11 Organisation for Economic Co-operation and Development, Thin Capitalisation; Taxation of Entertainers, Artistes, and Sportsmen, Issues in International Taxation no. 2 (Paris: OECD, 1987).

12 OECD guidelines, supra footnote 3, "Glossary."

13 Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as "the Act"), section 247. Unless otherwise stated, statutory references in this paper are to the Act.

14 Information Circular 87-2, "International Transfer Pricing and Other International Transactions," February 27, 1987, paragraph 9.

15 See Canada, Department of Finance, "OECD Transfer Pricing Guidelines Released," Release, no. 95-059, July 28, 1995, where the Department of Finance noted that the revised guidelines (1995) represented a "consensus among the 25 OECD member countries on how to approach transfer-pricing issues." Also see Canada, Department of Finance, "Draft Legislation and Information Circular on Transfer Pricing Released," Release, no.á97-076, September 11, 1997, where the Department of Finance states that "[t]he proposed rules are in conformity with the revised (1995) transfer pricing guidelines of the Organization for Economic Co-operation and Development. . . and are generally in keeping with the transfer pricing rules of other OECD member states, such as the US."

16 Supra footnote 2, at 24.

17 OECD guidelines, supra footnote 3, chapter I, paragraph 1.69.

18 OECD guidelines, supra footnote 3, chapter III, the OECD members agree that the theoretical alternative to the arm's-length principle represented by global formulary apportionment should be rejected.

19 OECD guidelines, supra footnote 3, "Glossary."

20 Section 247 of the Act.

21 Subsection 247(2) of the Act.

22 Subsection 247(3) of the Act introduced penalties effective for taxation years or fiscal periods that begin after 1998.

23 Subsection 247(3) of the Act. The penalty threshold is the lesser of 10 percent of the taxpayer's gross revenue and $5,000,000.

24 Paragraph 247(4)(a) of the Act requires that the documentation "provide a description that is complete and accurate in all material respects" of the items listed.

25 The Convention Between Canada and the United States of America with Respect to Taxes on Income and Capital, signed at Washington, DC on September 26, 1980, as amended by the protocols signed on June 14, 1983, March 28, 1984, March 17, 1995, and July 29, 1997 (herein referred to as "the Canada-US treaty"). Article VII addresses the calculation of branch profits of a Canadian corporation carrying on business in the United States that may be taxed by the United States. Pursuant to paragraph 2: "Subject to the provisions of paragraph 3, where a resident of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the business profits which it might be expected to make if it were a distinct and separate person engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the resident and with any other person related to the resident."

26 Subsection 126(2) of the Act.

27 Since a branch and the "home office" are both operating within the same corporate entity or taxpayer, the transaction is essentially between the taxpayer and itself.

28 At the time of writing this paper, we understand that the topic of branches and permanent establishments is under review by the OECD and member tax authorities, including the Canadian minister of national revenue.

29 Subsection 251(2) of the Act. Since ABC controls Subco and they are related for purposes of the Act.

30 Subsection 251(1) of the Act.

31 Subsection 247(2) of the Act. The US transfer-pricing legislation is in section 482 of the Internal Revenue Code of 1986, as amended.

32 The price paid by ABC for the shares approximates the net tangible asset value of the third-party seller company acquired.

33 The price paid by ABC for the shares exceeds the net tangible asset value of the third-party seller company acquired.

34 Revenue Canada draft Information Circular 87-2R, "Draft - Transfer Pricing," September 11, 1997, paragraph 66. "Certain costs are incurred for the sole benefit of shareholders and therefore should not be charged to other members of the group. For example, an independent entity would not bear the costs of a shareholders' meeting of an arm's length corporation."

35 OECD guidelines, supra footnote 3, chapter VII, at paragraph 7 and special considerations for intragroup services, at paragraphs 29 to 37; Information Circular 87-2R, supra footnote 37, paragraph 71.

36 Frantois Vincent, "Transfer Pricing in Canada: An Overview" (1996), vol. 5, no. 15 Tax Management Transfer Pricing Special Report, report no. 25. Mattel Canada Inc. had purchased certain television commercials from its US parent at an amount equal to their actual cost of production. Revenue Canada took the position that the amount charged should have been based on an allocation of cost similar to an administration fee or charge.

37 OECD guidelines, supra footnote 3, chapter 8, paragraph 8.31.

38 Canada-US treaty, supra footnote 29, article XII(3)(c). OECD guidelines, supra footnote 3, chapter VIII, paragraph 8.3 states that "each participant's proportionate share of the overall contributions to the arrangement will be consistent with the participant's proportionate share of the overall expected benefits to be received under the arrangement."

39 Ibid.

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