The non-arm's length transactions which can be subject to Canadian transfer pricing legislation include tangible products, intangibles, intra-group services and cost-contribution agreements. Recently, however, the Canada Revenue Agency ("CRA") has been focusing on financial transactions — namely the interest rates on intercompany loans.
Let's begin by providing an example of such a transaction and assume that a Canadian company, Canco, receives an intercompany loan of 1B$ from its parent, Forco, at a fixed rate of 10% over a 10-year period. Canco would pay 100M$ annually in interest to Forco, documented on the T106 Information Return as a financial interest transaction.
Canco must demonstrate the arm's length nature of the interest rate in its transfer pricing contemporaneous documentation. If the CRA disagrees, and proposes, as an example, a 9% interest rate, Canco could be looking at a transfer pricing adjustment of 10M$ per year on the loan, as well as an automatic referral to the transfer pricing review committee for the potential assessment of penalties.
How can taxpayers mitigate audit risk on intercompany financial transactions?
Generally speaking, taxpayers should proceed with the same analysis they would apply to any non-arm's length transaction with non-residents. They must identify the related parties to the transaction, define the covered financial transaction and determine the functions, assets and risks related to the entities and the covered transaction. For financial transactions, additional focus is generally placed on risk as a credit rating score will play a significant role in determining the interest rates available to the borrower.
As a result, transfer pricing documentation closely examines the risk-level of the borrower, specifically considering Canco's credit rating at the time the loan was entered into. As Canco is a separate entity in the arm's length world, it is very likely that a stand-alone credit rating will be required, unless it is determined that Canco will benefit from implicit support from its parent. First, verify if a credit rating agency, such as Standard & Poor's or Moody's, has already determined Canco's credit rating. If not, credit rating agencies publish credit rating methodologies to help estimate the stand-alone credit rating of an entity. While there are limits to these methodologies, they provide a valid approach to help determine Canco's risk level.
Once the credit rating has been determined, Canco will select a transfer pricing methodology to help establish the arm's length level of interest to be charged. One possible approach is to identify comparable loans by Forco to a third party (e.g. similar credit rating, equivalent loan terms, etc.) and proceed with reliable adjustments, if applicable, to determine an appropriate level of interest. If such agreements are not available or comparable, a search for third-party comparable loans with similar characteristics can help establish an arm's length range of interest rates for that credit level.
Canco's analysis will determine whether the 10% interest rate is consistent with what parties dealing at arm's length would have agreed to. If the 10% interest rate is an arm's length rate, the intercompany loan can be finalized and a transfer pricing report (i.e. contemporaneous documentation), covering all aspects outlined in paragraph 247(4)(a) of the Income Tax Act ("ITA"), will document the steps and the approach undertaken to determine and use an arm's length transfer price. The transfer pricing report will be prepared for the taxation year during which the intercompany loan was entered into.
Is a transfer pricing report required for subsequent years for the same loan?
According to paragraph 247(4)(b): "for each subsequent taxation year or fiscal period, if any, in which the transaction continues, makes or obtains, on or before the taxpayer's or partnership's documentation-due date for that year or period, as the case may be, records or documents that completely and accurately describe each material change in the year or period to the matters referred to in any of subparagraphs 247(4)(a)(i) to 247(4)(a)(vi) in respect of the transaction."
What would constitute a material change? Each loan is different, but generally, the terms of a loan are static and modifying the terms could generate significant penalties and/or incur significant financial and legal transaction costs. As a result, one would not expect any material change to the terms of the loan. If there are no material changes in subsequent years, the documentation prepared, including the assumptions and analysis used to document the transaction when the loan was executed in Year 1, should apply to subsequent years. From that perspective, any multinational enterprise would rightly interpret that they correctly determined arm's length prices when they entered into the intercompany loan and may not be required to prepare contemporaneous documentation for subsequent taxation years according to paragraph 247(4)(b), as there are no material changes to the terms of the loan.
However, other circumstances may be considered a material change. For example, Canco's credit rating could improve, allowing Canco to have access to better interest rates. Or, interest rates may trend lower over the term of the loan, implying that Canco's opportunity cost of holding the loan at that interest rate increases. These could be considered a "material change" that requires records or documents in subsequent years to show the interest rate remains arm's length. The underlying assumption by the CRA is that an arm's length borrower would seek a lower rate of interest, if available, without necessarily considering other financial considerations such as penalties, prepayment fees and financial and legal costs, related to loan renegotiation in an arm's length setting.
When producing transfer pricing documentation for Year 2, there is a high probability that the credit rating of the borrower has not changed, and the available interest rates are similar and within the range of the rate applied when the loan was executed. However, as time passes, the likelihood increases of a change in circumstances that would impact the credit rating of the borrower and the range of available interest rates, or changes in the economy which may have reduced interest rates in general.
Ultimately, while paragraph 247(4)(b) does not require that contemporaneous documentation be prepared unless there is a material change, taxpayers and the CRA could disagree on whether certain changes are material. Therefore, taxpayers often choose to document the loan each year to reduce the potential risk of penalties.
How would the CRA approach an audit of intercompany financial transactions?
The CRA would first request records or documentation showing Canco determined and used arm's length transfer prices. Once these records or documentation are provided, within three months of the request, the CRA could proceed with an audit of the financial transaction, issue audit queries and request functional interviews with key personnel at Canco. From experience, the CRA may focus on the market circumstances when the loan was entered into, the type of loan, the credit rating of the borrower and the range of interest rates in the year under consideration.
The CRA may also agree with the terms of the loan as established in the first year, but challenge the arm's length valuation of the interest rates and the credit rating in the later years. In this scenario, the core assumption is that Canco would seek a better interest rate from the lender if market rates have dropped or its credit rating has improved. The underlying terms of the loan will also be reviewed to determine Canco's flexibility in renegotiating the loan.
We've recently seen a number of transfer pricing audits on various intercompany loans where, as interest rates improved throughout the term of the loan, the CRA challenged and raised an income adjustment on the basis that the rate was no longer arm's length. Specifically, based on the example used in this article, if Canco entered into a loan in 2012, a 10% interest rate may have been within the arm's length range based on Canco's credit rating, but outside the range when rates trended lower in 2018 and 2019. While conceptually, any borrower would seek a better rate to lower their borrowing costs, other economic factors will limit their ability to do so at arm's length. This raises several questions: can Canco repay the intercompany loan and seek a different lender with a better interest rate? Is there a lender that would agree to the lower rate for Canco? Is there a penalty or prepayment fee to renegotiate the loan and how much does that offset the interest differential? What are the financial and legal fees associated with the change? How much would the terms of the loan change?
Anybody who has renegotiated a loan or mortgage understands there are underlying costs associated with early repayment and renegotiation. Based on our recent experience, however, these factors have not yet been addressed in CRA audits, even though they are routine in arm's length transactions.
While the example in this article speaks to Canco borrowing from its parent, Forco, the reverse scenario, where Canco is lending to a Forco, is also possible. In this situation, the CRA may review Forco's credit rating and validate the interest received by Canco on the intercompany loan. The same questions discussed above would accordingly apply in this scenario.
Also, a word of caution regarding the prescribed pertinent loans or indebtedness ("PLOI") rate. While one may assume this is an "acceptable" rate, as it is researched and published quarterly by the CRA, new subsection 247(2.1) provides an ordering rule which provides that the arm's length nature of the rate must first be determined, and the adjusted amount can be used in relation to other sections of the ITA . As a result, there may be situations where the CRA determines that the PLOI rate, even if properly applied by Canco, is not an arm's length rate under section 247.
How to manage an audit of intercompany financial transactions?
Documenting and validating the arm's length nature of the interest rate when the intercompany loan is established is key to demonstrating Canco has made reasonable efforts and preventing potential penalties. If the CRA requests a copy of the taxpayer's contemporaneous documentation, the taxpayer must present such contemporaneous documentation to the CRA within three months of the CRA's written request.
If, upon review of the taxpayer's documents, the CRA proceeds with further queries, they will likely focus on the terms of the loan and the credit risk determination, as this is closely linked to the interest rate of the loan. How Forco and Canco interact, whether or not there is implicit support by the parent, and other factors will be considered by the CRA.
Should the CRA proceed with an adjustment on the interest expense, normal dispute resolution mechanisms will be available, such as filing a request for mutual agreement procedure with the Canadian competent authority, a notice of objection with the CRA Appeals Directorate or a notice of appeal to the Tax Court of Canada.
In conclusion, while intercompany loans are commonplace within a multinational enterprise, the CRA's recent focus on these transactions should prompt taxpayers to proceed with utmost diligence when documenting and establishing an appropriate arm's length interest rate.
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.