This article was originally published in Blakes Bulletin on Cross-Border Taxation - March 2005
Transactions entered into between a Canadian taxpayer or partnership and a non-arm’s length non-resident are generally subject to the transfer pricing rules contained in section 247 of the Income Tax Act. If the terms and conditions, including any pricing arrangements, relating to such transaction are found to be different from those that would have been concluded between arm’s length parties, subsection 247(2) allows the Canada Revenue Agency (the CRA) to adjust the pricing of the transactions. The rules also permit the CRA to recharacterize such transactions where the structure utilized cannot reasonably be considered to have been adopted for non-tax reasons and such structure would not have been used by parties dealing at arm’s length.
In addition to a pricing adjustment, the Canadian taxpayer may be subject to penalties under the transfer pricing rules unless the taxpayer can demonstrate that it made reasonable attempts to determine arm’s length prices which would include the preparation of contemporaneous documentation with respect to the taxpayer’s efforts to determine arm’s length pricing.
Subject to proposed amendment discussed below, the transfer pricing rules apply to cross-border guarantees and other credit-related financial transactions. The application of these rules could result in income being imputed to a Canadian parent that has guaranteed the liabilities of one or more of its foreign subsidiaries. Double taxation could result since the foreign subsidiary would have paid no fee in the circumstances. In March 2003, the Department of Finance issued a "comfort letter" that indicated the Department’s intention to exempt certain guarantees from the application of the transfer pricing rules in section 247. Accompanying such letter was proposed subsection 247(7.1) which provided an exclusion from the transfer pricing adjustment provisions where a Canadian corporation had provided a guarantee to a non-resident if the following conditions were met:
the Canadian taxpayer provided the guarantee pursuant to an agreement in writing entered into with a lender or a person or partnership related to the lender;
the non-resident borrower was a controlled foreign affiliate of the Canadian taxpayer; and
the funds to which the debt that is subject to the guarantee relates were used in the affiliate’s active business operations.
The purpose of this proposed amendment is to provide an exemption to the transfer pricing rules for guarantees provided by a Canadian parent in respect of its controlled foreign affiliates similar to the exception from the deemed interest receipt provisions of section 17 which would apply to certain indebtedness owed by a non-resident to a Canadian taxpayer.
The first requirement described above, that being that the guarantee be provided pursuant to an agreement in writing entered into with the lender or person related to the lender, could significantly limit the availability of the proposed exception from the transfer pricing rules. It would not be uncommon for a Canadian parent to have provided a guarantee of the debt of a controlled foreign affiliate without there being an agreement in writing entered into with the particular lender. This, for instance, would often be the case where the controlled foreign affiliate carries out a public debt offering the terms of which include a parent guarantee of the widely held debt.
Furthermore, Finance has recognized that this first requirement is over-reaching and unnecessary. On December 7, 2004, the Department of Finance released a further comfort letter wherein the Department acknowledged that there is no policy reason why the exception should be limited to circumstances where there is a guarantee agreement entered into by the Canadian parent and the lender. Accordingly, the Department recommended that the requirement currently set out in proposed paragraph 247(7.1)(a) be dropped. The other requirements would remain. Proposed subsection 247(7.1) will apply prospectively with taxpayers having the ability to elect that it also apply for taxation years that begin after 1997.
An additional letter from the Department of Finance, dated January 24, 2005, confirmed the position taken in the December 7, 2004 letter with respect to guarantees of debt, but declined to extend the exception to be provided in proposed subsection 247(7.1) to guarantees of lease obligations without undertaking further study.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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