Canada: Revenue Canada Speaks Out on Transfer Pricing

Last Updated: October 5 1999
Article by David W. Steele

Revenue Canadaís long-awaited Information Circular 87-2R on transfer pricing was released in final form on September 27, 1999 (replacing the draft Information Circular of September 11, 1997). The final Circular describes Revenue Canadaís views on transfer pricing and warrants serious attention. It provides guidance with respect to the application of the armís length principle and section 247 of the Income Tax Act (the Act). The Circular is only the first in a series of Revenue Canada Technical Memoranda that will explain their positions on transfer pricing.

This article provides an overview of how Information Circular 87-2R differs from the original 1997 draft, and highlights areas of concern to taxpayers. For a detailed discussion of transfer pricing methods and other issues particular to your circumstances, it is strongly recommended that you contact a Canadian transfer pricing practitioner (see end of article).

The final Circular arrives none too soon, given that companies with calendar year ends are now completing the third quarter of the first fiscal year in which transfer pricing penalties will be enforced. Also, Revenue Canada is already asking taxpayers if they have prepared contemporaneous documentation on the new form T106, which is required for filings after September 30, 1999.

Information Circular 87-2R is much longer than the original draft (225 paragraphs versus 100). As with the draft Circular, the final version is divided into twelve parts as follows:

  1. The Law
  2. The Armís Length Principle
  3. Armís Length Methods
  4. Qualifying Cost Contribution Arrangements
  5. Intangible Property
  6. Intra-Group Services
  7. Penalty Ė Reasonable efforts
  8. Customs Valuations
  9. Confidentiality of Third Party Information
  10. Part XIII Withholding Tax
  11. Competent Authority Procedures
  12. Advance Pricing Agreements

There have been no major changes in Revenue Canadaís interpretation of the armís length principle. The final Circular merely elaborates on Revenue Canadaís views on the above topics and provides more comprehensive examples.


Taxpayers and practitioners were hoping for a meeting of the minds on methodologies that will satisfy both Canadian and U.S. tax authorities. Although the Circular pays lip service to the most prevalent U.S. method, the comparable profits method (CPM), the conditions placed on its use, as well as a stated preference for the profit split method, do not give any comfort that cross-border audits will be expedited in the future.


The Law

Additions to the section about the law highlight two important issues: the timing of the penalties as they apply to "transactions completed before September 11, 1997" and financing transactions.

Revenue Canada has clarified that continuing transactions (such as licence or supply agreements) signed before September 11, 1997 are not exempt from the penalty provisions. The only exempt transactions are single transactions (such as the purchase of inventory) that were completed before September 11, 1997, but nevertheless affect the financial statements after that date.

With respect to financing transactions, Revenue Canada has clarified that section 247 could be applied to a wide variety of arrangements, resulting in foreign accrual property income to Canadian shareholders. Although the Circular states Revenue Canadaís view that subsection 247(2) of the Act was not intended to change the existing law as it relates to intercorporate debt and equity investments, if the arrangement is one to which the general anti-avoidance rule ("GAAR") could be applied, Revenue Canada may decide to use subsection 247(2) instead of GAAR.

The Armís Length Principle

The Circular reiterates Revenue Canadaís view that the armís length principle should be applied transaction by transaction. This approach has always differentiated Canadian transfer pricing from the U.S. rules, where many transactions may be tested together through a review of the "tested partyís" profitability, using the CPM. Revenue Canada is clearly stating that transfer prices should be established for each type of transaction such as tangible goods, royalties, or services, but is also retaining the option of reviewing transfer pricing on a product by product basis.

Revenue Canada will look at normal industry practice when determining whether transactions should be bundled or unbundled. Unbundling a transaction into its tangible and intangible components can result in withholding tax under Part XIII of the Act. Taxpayers whose practices differ from industry norms may find this interpretation problematic, because bundled transactions on which they currently do not pay withholding tax may be unbundled. Revenue Canada does not view this practice as a "recharacterizeration" requiring review by the new Transfer Pricing Review Committee.

Armís Length Methods

Consistent with the OECD Guidelines, Revenue Canada expresses a clear preference for transactional methods over profit based methods, but goes one step further by indicating a preference for the profit split method over the transactional net margin method (TNMM). This stated preference fails to recognize that each method is appropriate in certain circumstances and that they are not substitutable. The profit split is necessary when both parties to a transaction own valuable intangibles and therefore neither party can be compared to independent companies performing routine functions. Revenue Canadaís push to use profit split fails to recognize a distinction between unique valuable intangibles and routine intangibles that can be properly compensated through the TNMM. The Circular included a detailed example of the use of the profit split method and Revenue Canada clearly intends to push for its use.

In practice, the stated preference for the profit split method may encourage Revenue Canada auditors to inappropriately demand information concerning foreign related partiesí profitability. This raises the issue of whether foreign based information should be provided, and may prolong audits while the need to see how profit is split among all related foreign entities is debated.

An effective way to avoid the application of the profit split method would be to ensure that all valuable intangibles are owned by one party and therefore the other ("tested") party can be given a routine return for its functions and risks. To avoid the push for profit split, a taxpayerís choice of methodology needs to be well supported.

Since 1994, when the United States began to enforce its transfer pricing regulations and the CPM method became widely used, Revenue Canada has resisted the use of this method and stated that it will not be acceptable in Canada. The final Circular refines this statement, stating that the CPM will be acceptable in Canada, if transactional methods cannot be applied, and only as long as it conforms with the comparability standards set forth for the TNMM. However, whereas the U.S. regulations state that statistical measures (the use of the interquartile range) should be used to enhance the reliability of a sample of comparable data, Revenue Canada does not endorse these measures, and instead, intends to rely on the facts and circumstances of the case to determine a range or a particular point in a range that is the most reliable estimate of an armís length price or allocation. This statement gives auditors the flexibility to choose any point in a range rather than recognizing that all points in a range may be equally reliable. Thus, the concession that Revenue Canada will accept the CPM is countered by its refusal to follow the CPM rules with respect to the determination of an armís length range.

While it is recognized that there is a need to improve the level of comparability when using the TNMM, Revenue Canada should not lose sight of the fact that transfer pricing is an art and not a science.

Intangible Property

The discussion of intangible property seems intended to give auditors plenty of leeway to impute valuable intangibles resulting from the activities of Canadian distributors, and thus push taxpayers towards a profit split method. The Circular comments that:

  • licensees of intangible property should be expected to share in some of the residual profit associated with those intangibles; and
  • distributors that bear the cost of marketing activities should be allowed to share in the return from marketing intangibles.

These inferences leave the door wide open for auditors to impute valuable intangibles in Canada. The problem is that their counter-parties in the United States will view these entities as routine distributors and may try to establish reasonable profitability through the use of the CPM. In the end, the debate will focus on a detailed analysis of the functionality of the parties, the ownership of valuable intangibles, and the true comparability to unrelated companies used in the creation of the armís length range of profits.

The flip side of Revenue Canadaís attempt to impute intangibles to Canada is their desire to protect Canadian-developed intangibles from migrating offshore. The Circular questions whether armís length parties would permit the long-term exploitation of a valuable intangible at all. Variable royalties tied to profits or short-term, adjustable agreements may be expected as alternatives to an outright sale. This approach looks surprisingly like the U.S. "commensurate with income" rules that are intended to ensure that the owner of an intangible is properly compensated over time. Whereas the U.S. rules clearly will use hindsight, it appears that Revenue Canadaís approach will simply be to say that the original sale was not made on armís length terms and therefore can be adjusted later.

In structuring the sale or licensing of intangibles, taxpayers should be extremely careful to ensure that they mirror terms that can be found between armís length parties in similar circumstances. The Circular specifically says that Revenue Canada:

  • will review any long-term sale of intangibles between related parties for consistency with the armís length principle; and
  • is prepared to adjust sale transactions to reflect ongoing royalty agreements if the transaction would not have been entered into between persons dealing at armís length, and was not entered into for bona fide purposes other than to obtain a tax benefit.

Taxpayers must take every precaution to find comparable armís length sales to justify these transactions, and document a sale with a comprehensive valuation.


Revenue Canadaís concern with services has historically been whether a markup can be added to the cost of providing the service. The Circular addresses this issue in a manner that leaves open the possibility of assessing either way. If the activities can be seen as administrative or ancillary in nature, Revenue Canada believes that centralization of the activity would occur only if all parties could share the cost savings and therefore that cost would represent an armís length charge. Alternatively, Revenue Canada may argue that the service provider is not as efficient as independent service providers if it is not its ordinary or recurring activity. In circumstances that do not violate these tests, a markup should be acceptable.

Penalty Ė Reasonable Efforts

Several paragraphs have been added to describe the application of the penalty and Revenue Canadaís view on reasonable efforts. Lists of required documents have been provided for tangible goods, qualifying cost contribution arrangements and intangible property. As expected, Revenue Canadaís view is that reasonable efforts are extensive. The promised Technical Memoranda Series likely will provide more guidance in this area.


In summary, Information Circular 87-2R seems to provide Revenue Canada auditors with tremendous leeway in assessing the armís length principle and provide the tools necessary to challenge the transfer of intangibles offshore.

The new T106 reporting form directly asks taxpayers if they have prepared contemporaneous documentation. Revenue Canada is hiring 175 transfer pricing auditors across the country to ensure compliance with these rules.


Members of the Transfer Pricing team at PricewaterhouseCoopers LLP are ready to help you:

  • meet the contemporaneous documentation requirements;
  • identify potential exposure to penalties; and
  • improve the likelihood of success on audit.

For further information, please contact any of the following transfer pricing practitioners across Canada:

Brenda Humphreys (905) 897-4514
Saul Plener (905) 949-7310
Claude Lemelin (514) 205-5115
Andrew McCrodan (416) 869-8726
Barry Macdonald (604) 806-7888
Murray Robertson (604) 806-7811
Charles Thériault (403) 509-7500


* * * * * * * * * * * * * * * *


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.

PricewaterhouseCoopers refers to the Canadian firm of PricewaterhouseCoopers LLP and other members of the worldwide PricewaterhouseCoopers organization.

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