Canadian Transfer Pricing Update
The following provides an overview of the new Canadian transfer pricing legislation and discusses some of the related issues.
On September 11, 1997, draft amendments to the Income Tax Act relating to the transfer pricing measures announced in the 1997 federal budget were released. The draft legislation was accompanied by draft revisions to Information Circular 87-2R (IC 87-2R) which outlines Revenue Canada's administrative practices in the transfer pricing area. After considering feedback and commentary from interested parties, the Department of Finance issued revised transfer pricing legislation on December 8, 1997 in a Notice of Ways and Means Motion which was introduced into Parliament in early 1998 as Bill C-28. This Bill has received Royal Assent and is now law. For many corporations, the new law means additional transfer pricing documentation will be required in order to avoid substantial penalties.
The highlights of the new transfer pricing rules are as follows:
For the first time, explicit legislative recognition is given to the "arm's-length principle". The arm's-length principle has been endorsed by the Organisation for Economic Co-Operation and Development ("OECD"). In general terms, this principle requires that taxpayers conduct their transactions with non-arm's-length parties on the same terms and conditions that would have prevailed if they had been dealing at arm's-length. The new Canadian rules are largely based on the OECD Guidelines.
Effective for taxation years beginning after 1997, Revenue Canada has the authority to make adjustments to non-arm's-length transactions if they deem that the transactions are not in accordance with the arm's-length principle or that they would not have been entered into between persons dealing at arm's-length.
Penalties can apply for taxation years beginning after 1998. Transfer pricing adjustments that result in an increase in income or the cost base of assets or a decrease in loss may be subject to a 10% penalty. Setoffs may be allowed in certain situations to reduce the amount of adjustments subject to penalty.
Taxpayers are required to have "contemporaneous documentation" in place to support all cross-border transactions in order to avoid the application of penalties.
IC 87-2R has been revised to ensure that all the various methods described in the OECD Guidelines are available to taxpayers. The OECD Guidelines recommend five specific arm's-length pricing methods which can be divided into two groups; traditional transaction methods and transactional profit methods.
"Where a taxpayer ... and a non-resident person with whom the taxpayer ... does not deal at arm's-length ... are participants in a transaction ..., and
(a) The terms and conditions made or imposed, in respect of the transaction ..., between any of the participants in the transaction ... differ from those that would have been made between persons dealing at arm's-length, or
(b) The transaction ... would not have been entered into between persons dealing at arm's-length, and can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit any amounts that ... would be determined for the purposes of [the Act] in respect of the taxpayer ... and the nature of such amounts shall be adjusted to the quantum or nature of the amounts that would have been determined if
(c) Where only paragraph (a) applies, the terms and conditions made or imposed ... between the participants in the transaction ... had been those that would have been made between persons at arm's-length, or
(d) Where paragraph (b) applies, the transaction ... had been the transaction ...that would have been entered into between persons dealing at arm's-length, under the terms and conditions that would have been made between persons dealing at arm's-length.
As can be seen, where arm's-length parties would not have entered into the transaction, the scope for Revenue Canada to adjust the nature of the transaction is restricted to circumstances where the transaction has no bona fide purpose other than to obtain a tax benefit. "Tax benefit" for this purpose is defined as it is under the General Anti-Avoidance Rules as a reduction, avoidance or deferral of tax (or increase in refund of tax).
The transfer pricing legislation allows favourable adjustments to reduce unfavourable adjustments in certain circumstances. "Setoffs" shall only be made where "in the opinion of the Minister, the circumstances are such that it would be appropriate that the adjustments be made". In other words, taxpayers must receive the Minister's approval in order to offset unfavourable adjustments with favourable adjustments.
For tax years commencing after 1998, new transfer pricing penalty provisions apply. Transfer pricing adjustments which result in a net increase in income or a net decrease in loss will be subject to a 10% penalty, subject to certain exceptions:
Penalties will not be applied where the net transfer pricing adjustment does not exceed the lesser of 10% of the taxpayer's gross revenue or $5 million; and
No penalties will be applied where taxpayers have used reasonable efforts to determine that their prices are arm's-length and documented such on or before their tax return filing deadline for the taxation year. Taxpayers must be able to provide this documentation to the Minister of National Revenue within three months of a written request therefor.
One important feature of the new transfer pricing penalties is that they are based on the amount of the transfer pricing adjustment rather than the resulting tax liability and, therefore, can apply even when the taxpayer is in a loss position such that no increased taxes are payable as a result of the adjustment. The proposed penalties may also apply to adjustments to the cost base of capital property. The capital adjustments are defined as 75% of reductions to the adjusted cost base of capital property (other than depreciable property) or eligible capital expenditures and 100% of reductions to the capital cost of depreciable capital property.
Adequate documentation of cross-border inter-company pricing is the first line of defence in audit situations and is integral to success against challenge by Canadian or foreign tax authorities. Canada has, for a number of years, had a relatively aggressive program of transfer pricing enforcement. Even in the absence of formal documentation rules, the long-standing policy of strict enforcement has, to some extent, led to a de facto need for taxpayers with large potential transfer pricing exposures to maintain detailed support for their transfer pricing policies to have available in the event of a Revenue Canada audit.
For tax years commencing after 1998, the new transfer pricing provisions apply. Any transfer pricing adjustment may be subject to a 10% penalty unless the taxpayer has made reasonable efforts to determine arm's-length transfer prices. This requires contemporaneous documentation to be on hand at the time the tax returns for the year are due (i.e. six months after the end of the tax year).
As a minimum, the taxpayer should have a complete and accurate description of the following:
The property or services to which the transaction relates;
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;
An organization chart showing the identity of the participants in the transaction and their relationship to each other at the time the transaction was entered into;
A functional analysis describing the functions performed, the property used or contributed and the risks assumed, in respect of the transaction, by the participants of the transaction;
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
The assumptions, strategies, 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.
Compensation for transactions between non-arm's-length parties is a factor of the relevant functions performed and risk assumed by each of the parties. Therefore, a functional analysis will normally be a fundamental component of any transfer pricing analysis, regardless of the pricing method used. The documentation requirements outlined in the legislation contemplate the use of a functional analysis.
For taxpayers with December 31 taxation years, the first deadline for having contemporaneous documentation supporting the prices used in their cross-border non-arm's-length transactions is June 30, 2000.
SOME AREAS OF CONTENTION
As discussed above, the transfer pricing penalties will be imposed on unfavourable adjustments without regard to the tax status of the taxpayer. Therefore, taxpayers in loss positions, and possibly with the least ability to pay, may be subject to penalties as well as non-deductible interest charges. This could constitute a significant hardship to many taxpayers.
In general, Canada's penalties may have a harsher result than their U.S. counterpart and, possibly, than the OECD Guidelines endorse. This result arises due to the fact that, in Canada, penalties are imposed on adjustments rather than resulting understatements of tax, non-deductible interest charges may apply and the $5 million threshold is actually lower than the U.S. threshold once the currency translation is considered. Further, various conditions must be met in order for favourable adjustments to be offset against unfavourable adjustments when calculating the penalty.
Level and Scope of Analysis Documentation
Both the OECD Guidelines and Revenue Canada's administrative position indicate that scope of a taxpayer's transfer pricing analysis and resulting level of documentation should be "in accordance with the same prudent business management principles that would govern the process of evaluating a business decision of similar complexity and importance."
The legislation and administrative comments in IC 87-2R leave substantial room for the use of taxpayer judgement to determine what constitutes reasonable efforts. Although this recognizes the variety of business transactions and decision-making techniques and avoids the application of a rigid and narrow view of the analysis and information needed to establish arm's-length prices, the lack of practical guidance and clarity on what the authorities consider to be reasonable efforts creates uncertainty and subjectivity in this area.
The September 11, 1997 draft legislation gave the Minister broad powers to recharacterize non-arm's-length transactions that would not have been entered into between arm's-length parties. The main concern was that the proposed legislation did not contain sufficient explicit safeguards against excessive recharacterization of the transactions entered into by a taxpayer. This power of recharacterization created concern that normal business transactions might be routinely challenged. This was particularly a concern because Revenue Canada has the ability to challenge the limited instances where it is necessary to recharacterize a transaction under the general anti-avoidance provisions.
Due to the adverse reaction by taxpayers and submissions made by taxpayers and tax practitioners, the revised legislation narrowed the circumstances under which transactions may be recharacterized. The legislation provides the Minister the power of recharacterization only where:
- (a) The non-arm's-length transactions entered into would not have been entered into between arm's-length parties; and
- (b) The transaction can reasonably be considered to have been entered into to obtain a tax benefit and not primarily for bona fide purposes.
The fact that Revenue Canada has not set out any significant guidance in IC 87-2R as to when it may exercise this power of recharacterization is still of significant concern to many taxpayers.
The information provided herein is for general guidance on matters of interest only. The application and impact of laws, regulations and administrative practices can vary widely, based on the specific facts involved. In addition, laws, regulations and administrative practices are continually being revised. Accordingly, this information is not intended to constitute legal, accounting, tax, investment or other professional advice or service.
While every effort has been made to ensure the information provided herein is accurate and timely, no decision should be made or action taken on the basis of this information without first consulting a PricewaterhouseCoopers LLP professional. Should you have any questions concerning the information provided herein or require specific advice, please contact your PricewaterhouseCoopers LLP advisor, or: