PLEASE NOTE: THIS INFORMATION WAS ORIGINALLY SUBMITTED BY COOPERS & LYBRAND, CANADA
It has already been widely reported that the federal government used the occasion of its 1997 budget to outline changes to Canada's transfer pricing provisions. The following paragraphs will provide additional commentary on documentation requirements and penalty provisions aimed at ensuring compliance. All Canadian companies, partnerships, trusts and individuals having business transactions with related non-residents will be affected by these new provisions.
The federal budget statement last month made it clear that Revenue Canada is serious about making taxpayers comply with the "arm's-length principle" when dealing with related non-resident companies.
The budget announced that taxpayers must have "contemporaneous documentation" to support all cross-border transactions, including product transfers, license fees, royalties, commissions and management fees, for taxation years beginning after 1997. Failure to provide the relevant information to justify transfer prices will result in penalties, which are expected to be calculated as a percentage of any adjustments that Revenue Canada makes to taxpayers' incomes arising from incorrect pricing.
Revenue Canada will soon begin to conduct a consultation process before they issue details as to the extent of the documentation required and the formula for the penalties. Until that time, we can make some informed guesses on questions that may be on taxpayers' minds.
WHAT DOES "CONTEMPORANEOUS DOCUMENTATION" MEAN?
The budget announcement did not give details on the level of documentation that will be required. However, there are precedents that Revenue Canada may look to in setting its guidelines.
In the United States, Canada's prominent trading partner, the tax regulations set out certain requirements that must be met to avoid a transfer pricing penalty. The minimum level of documentation includes:
- An overview of the business, including the economic and legal factors that affect pricing;
- A description of the organizational structure;
- A description of the method used to set prices and reasons why it was selected;
- An analysis of the other methods that were considered and why they were not chosen;
- A description of the related party transactions;
- An analysis of the comparables used, how comparability was evaluated and what adjustments were made; and
- An explanation of the economic analysis and projections relied upon.
Additional items that we might expect Revenue Canada to require are the legal agreements underlying the transactions and the division of profit on the transaction between the related parties.
CAN WE USE THE DOCUMENTATION PREPARED FOR U.S. PURPOSES?
The level of analysis required for U.S. purposes will probably suffice in Canada, but the focus of the analysis may not be appropriate. Any existing U.S. analysis must be examined to avoid contradicting it in a separate Canadian analysis.
When developing a strategy to comply with the proposed documentation requirements, consider the following:
- Often the documentation prepared for U.S. purposes is done on a "U.S. vs. the rest of the world" basis. Little or no attention may be paid specifically to Canadian operations.
- The U.S. analyses are sometimes concerned only with the adequacy of U.S. profitability and make no comment on the fairness of the transactions to Canadian or other related parties.
- Canadian functions are likely to differ from those performed in the U.S. (For example, the U.S. company may manufacture and distribute whereas the Canadian company merely distributes.) The approach taken, and comparables used, to test the reasonableness of the transfer prices may be completely different.
- A U.S. analysis may have useful industry information that is relevant to the Canadian company and may save time in preparing the Canadian documentation.
WHAT ABOUT DIFFERENCES IN APPROACH TO TRANSFER PRICING? WILL CANADA ACCEPT THE COMPARABLE PROFITS METHOD?
Revenue Canada has adopted the 1995 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations as proposed by the Organisation for Economic Co-Operation and Development ("OECD"). These guidelines are very much like the U.S. tax regulations, but with certain exceptions.
One such exception is that profit-based methods, like the Comparable Profits Method, are considered a "last resort" by the OECD. In practice, since transactional comparables are difficult to find, the transactional methods preferred by the OECD are more the exception than the rule.
Canadian legislation does not clearly permit profit-based methods now. The budget announcement stated that the Income Tax Act will be amended to allow the profit-based methods. Once taxpayers have demonstrated that they cannot apply the transactional methods, they can use a profit-based method and should arrive at the same transfer pricing conclusion under either the U.S. or OECD rules.
HOW WILL REVENUE CANADA ENFORCE THIS REQUIREMENT?
Over the past few years increased manpower has been allocated to transfer pricing audits by Revenue Canada and the budget release says this will continue. To give the auditors clout, penalties will be levied against taxpayers that do not comply with the documentation requirements or do not act diligently in establishing transfer prices. However, the budget provides no indication of the severity of the penalties. It merely indicates that they will be "commensurate" with the transfer pricing adjustment.
WHAT PRECEDENTS ARE THERE FOR PENALTIES?
In the U.S., the Internal Revenue Code levies penalties as high as 40% of any transfer pricing adjustment. The U.S. system penalizes a taxpayer more heavily as the adjustment increases in relation to the prices originally used on filing of the tax return. In Australia, the penalty starts at 25% but can reach 50% of the adjustment if the taxpayer is found to be using transfer pricing for tax avoidance. In informal discussions, the Canadian government officials have not offered any comfort that the Canadian penalties will be less severe than those levied by the U.S. or Australia.
WILL THE PENALTIES BE DEDUCTIBLE?
No, penalties (and interest) imposed by Canadian income tax legislation and regulations cannot be deducted for tax purposes, thus significantly increasing their cost.
IS THIS REALLY A CHANGE FROM REVENUE CANADA'S HISTORIC POSITION ON TRANSFER PRICING?
No, not in principle, but enforcement is another matter. Revenue Canada has informally adopted the OECD guidelines since their initial release and has always followed the arm's-length principle. We have been advising clients for the past decade to document their policies and maintain records to prove that they are arm's-length. These proposed changes only increase Revenue Canada's ability to successfully protect the Canadian tax base.
HOW MUCH TIME DO WE HAVE TO GET THIS ANALYSIS DONE?
The documentation requirements will be in force for taxation years that begin after 1997. Accordingly, calendar year taxpayers must have the documentation in place by June 30, 1999, when they file their tax returns for the year ended December 31, 1998.
Preparation of adequate documentation takes significant time and effort. Don't wait until the last minute to initiate the process.
Coopers & Lybrand staff are available to help. We have experienced transfer pricing professionals in Canada and around the world.
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 Coopers & Lybrand professional. Should you have any questions concerning the information provided herein or require specific advice, please contact your Coopers & Lybrand advisor, or:
David W. Steele PricewaterhouseCoopers 145 King Street West Toronto, Ontario M5H 1V8 Canada Fax: 1-416-941-8415 E-mail: Click Contact Link
Click Contact Link