Prompted by government concerns about the depletion of Canada’s tax base, tax authorities here are now using transfer pricing principles as a primary audit tool to evaluate – and challenge – income allocation to Canada by multinationals. As a result, virtually all cross-border business activities between related parties are now subject to transfer pricing audits. Here, we look at some of the key areas tax authorities are zeroing in on.
In less than 10 years, cross-border transfer pricing principles in the Canadian tax system have undergone a metamorphosis. From a supporting role – as a relatively minor and infrequently enforced compliance measure for pricing goods and services between related parties generally – transfer pricing has become the predominant analytical tool for policing the extent to which a multinational group's profits are subject to Canadian taxation.
International transfer pricing audits are being pursued vigorously, and with a significant deployment of sophisticated resources, by the Canadian tax authorities. The resolution of transfer pricing controversies can be involved and time consuming. In addition, corporations seeking redress for a reassessment through the appeals and competent authority processes must first pay one-half of the reassessed liability on account of tax that may never be owed.
Canadian transfer pricing rules and guidelines focus on transactional tax consequences. However, their underlying theme, which guides their application by both tax authorities and taxpayers, is concerned fundamentally with justifying the allocation of a shared international tax base – multinational profit – among national tax systems able to assert a legitimate tax claim.
From a taxpayer’s perspective, more than ever, the objective of thoughtful transfer pricing is to establish a reliable, defensible correspondence between the reported financial income for tax purposes of the members of a multinational group and their respective "economic income" based upon their functional contributions to the group’s income-earning enterprise.
Evolving Administrative Practices
Prompted by concerns of Canadian and foreign revenue authorities about the depletion of their respective tax bases, tax authorities here are now using transfer pricing principles as a primary audit tool to evaluate – and challenge – income allocation to Canada by multinationals. This increased Canadian focus on transfer pricing has extended the scope of transfer pricing audits to virtually all cross-border business activities between related parties. It has resulted in continuously evolving administrative practices, different in some cases from historical approaches in this area.
The analytical dimensions of Canadian transfer pricing are directly linked to whether a non-resident has a taxable business presence in Canada, by having a permanent establishment with meaningful attributable income, as a consequence, for example, of functions performed by or for it in this country. The importance and sophistication of transfer pricing analysis in Canada is illustrated in several areas, including:
Transfers of intangible property and the performance of services.
Such transfers should be examined through the application of suitable analytical methodologies. Of particular note is the expectation by the Canadian tax authorities that the elements (assuming they can be identified) of complex "bundled" transfers should be evaluated as stand-alone transactions according to analytical tests that may not be the same for each embedded transfer.
Existence of a "taxable presence" in Canada.
Increasingly, business functionality is being used to determine the existence of a taxable presence in Canada. This directly feeds consideration by taxpayers of whether to reduce or increase the scope and extent of a business presence within a jurisdiction, for example by transforming a licensed manufacturer and distributor to that of a toller, contract manufacturer and/or limited function distributor.
Intra-group service and similar arrangements.
Such arrangements may have the effect of transferring intangible property outside Canada. Also drawing the tax authorities’ attention are fees for services continuously charged on a bundled basis. The Auditor General of Canada has encouraged the tax authorities to evaluate these kinds of arrangements.
This remains a significant focus of transfer pricing practice because of increasingly rigorous compliance expectations. It is also used as a planning device to assist in analyzing and organizing the relative contributions of members of a corporate group. The Canadian Income Tax Act sets out certain broad expectations on the kinds of documentation that should be prepared contemporaneously with filing a tax return or which should at least be available for delivery to the tax authorities within three months of a specific request.
Planning Includes Forum Selection
These dimensions of Canadian transfer pricing greatly increase the likelihood of transfer pricing disputes with and between tax authorities. This risk increases to the extent that tax jurisdictions may not apply common analytical approaches or, in some cases, legal standards. As a result, even the most orthodox corporate tax planning should anticipate, from the outset, the forums in which a taxpayer may be required to explain and defend the international allocation of multinational income, and how (and in what forum) such advocacy may be conducted.
Transfer pricing is the encapsulation of all of the more specific aspects of international tax planning. Importantly, it may be the arena in which the adequacy of that planning to achieve business objectives is tested.
Scott Wilkie and Blake Murray, partners with Osler’s National Tax Department, are ranked among Canada’s top practitioners in Euromoney’s 2003 Guide to the World’s Leading Transfer Pricing Advisers
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