The Income Tax Act (Canada) (the "Tax Act") contains an extensive set of transfer pricing rules designed to ensure that cross-border transactions entered into between Canadian taxpayers and non-residents with which they do not deal at arm's length are priced on an "arm's length" basis. For instance, where a Canadian-resident taxpayer has paid more than an "arm's length" price to a non-resident with which they do not deal at arm's length for a good or service, the transfer pricing rules can apply to increase the taxable income of the Canadian taxpayer by deeming the amount paid for such good or service to be equal to the applicable arm's length price. Such a pricing adjustment is generally referred to as a "primary adjustment".
Under the foregoing circumstances, the Canada Revenue Agency (the "CRA") has also generally sought to make "secondary adjustments" to account for the increased amount paid to the non-resident as a result of the operative price of the subject good or service being in excess of an arm's length price. Prior to Budget 2012, the CRA made these secondary adjustments on the basis of provisions of the Tax Act outside of the transfer pricing rules. For example, where the non-resident was a shareholder of the Canadian taxpayer, the secondary adjustment would generally be treated as a "shareholder benefit" that was deemed, under existing provisions of the Tax Act, to be a dividend subject to non-resident withholding tax. However, where the related non-resident was not a shareholder, the technical basis for assessing a secondary adjustment was sometimes less clear.1
Prior to Budget 2012, the CRA would also generally be open to administratively providing relief from secondary adjustments where:
- the Canadian taxpayer agreed in writing to the proposed transfer pricing adjustments (the taxpayer could still seek relief under the Mutual Agreement Procedure article of an applicable tax treaty);
- the adjustments did not arise from a transaction that may be considered abusive; and
- the non-resident repatriated the excess payment immediately or agreed in writing to repatriate such amount within a reasonable time.2
For the most part, Budget 2012 proposes to codify the administrative practices with respect to secondary adjustments that the CRA has followed for a number of years. Specifically, amendments to the Tax Act will be introduced such that, in respect of transactions that occur on or after Budget Day (i.e., March 29, 2012), the excess payment resulting from a primary adjustment involving a Canadian-resident corporation will generally be deemed to be a dividend paid by the corporation to the non-resident party to the subject transaction at the end of the taxation year in which the primary adjustment is made, regardless of whether the non-resident is a shareholder of the corporation. The deemed dividend will be subject to non-resident withholding tax levied at the statutory rate of 25%, subject to reduction under an applicable tax treaty.
The one exception to this rule will arise where the non-resident is a "controlled foreign affiliate" (as defined in subsection 17(15) of the Tax Act) of the Canadian corporation at all relevant times, in which case no secondary adjustment will apply on the basis that the excess payment is more akin to a capital contribution than a dividend.
repatriation to avoid a deemed dividend
Budget 2012 also proposes to codify the administrative practices currently maintained by the CRA in respect of repatriations of excess payments by corporations that are subject to a transfer pricing adjustment. Specifically, where an excess payment results in a deemed dividend, and some or all of the payment has been repatriated to the Canadian corporation, it is proposed that the amount of the deemed dividend may be reduced with the concurrence of the Minister of National Revenue (the "Minister") to an amount that the Minister considers appropriate having regard to, among other things, the amount being repatriated. Accordingly, the ability to reduce the quantum of a deemed dividend under the new proposals will continue to be dependent, to a large extent, on the judgment of the Minister.
It is expected that the CRA will generally continue to apply the same historical criteria when assessing whether to grant relief from a secondary adjustment where excess payments are repatriated to the Canadian corporation, including denying relief where the adjustments arose from one or more transactions that may be considered abusive. The CRA has previously stated that the following circumstances could be taken to indicate an abusive transaction in the transfer pricing context:
1. A penalty under the Tax Act has been applied to the transaction or series of transactions;
2. The Canadian corporation has failed to provide required contemporaneous documentation relating to the transaction that was requested by the CRA;
3. The Canadian corporation or a related non-resident has failed to honour a requirement to provide documents or information relating to the transaction issued under the Tax Act; and
4. The CRA's Transfer Pricing Review Committee has approved the application of paragraph 247(2)(b) of the Tax Act, or the CRA's GAAR Committee has approved the application of the general anti-avoidance rule, as a secondary basis to justify the subject assessment.3
interest on deemed dividend
Under the proposed amendments, interest on tax not withheld and remitted in respect of a deemed dividend will be payable for the period starting when the excess payment from the Canadian corporation that gave rise to the deemed dividend is made until the amount is repatriated from the non-resident. Under the proposed rules, such interest amount can be reduced by the Minister having regard to all the circumstances, including whether the country of the non-resident provides reciprocal treatment.
The transfer pricing proposals contained in Budget 2012 re-affirm the strong focus of the CRA on transfer pricing compliance and cross-border transactions between parties that do not deal with one another at arm's length. Canadian corporate taxpayers would be well advised to continue to be vigilant in ensuring that their chosen cross-border transfer prices can withstand scrutiny.
1. See, for example, the comments of the Transfer Pricing Subcommittee of the Advisory Panel on Canada's System of International Taxation – available at http://www.apcsit-gcrcfi.ca/06/rr-re/2950_FC_CSIT_RR1_E_VF.pdf.
2. See, Canada Revenue Agency, Transfer Pricing Memorandum – 02 "Repatriation of funds by non-residents – Part XIII assessments" (27 March 2003) – available at http://www.cra-crc.gc.ca/tx/nnrsdnts/cmmn/trns/tpm02-eng.html.
The foregoing provides only an overview. Readers are cautioned against making any decisions based on this material alone. Rather, a qualified lawyer should be consulted.
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