Transfer Pricing Update Canada

Introduction

Some transfer pricing trends are beginning to emerge that taxpayers should be aware of and be prepared to address in the course of preparing for an audit. Observers have noted:

• the CRA's use of the "recharacterization" and penalty provisions in Canada 's transfer pricing rules;

• a strain in relations between Canada and its trading partners, especially the United States, relating to transfer pricing issues; and

• the CRA assessment of non-arm's length transactions based on provisions of the Canada Income Tax Act (the "Act") other than section 247 or the transfer pricing  provisions that were in place prior to 1998.

Canada has also been involved with OECD projects that deal with profit attribution to permanent establishments as well as with the activities of the Pacific Association of Tax Administrators ("PATA").

Transfer Pricing – Section 247 of the Act

Canada 's current transfer pricing regime has been in place since 1998. The transfer pricing rules are set out in section 247 of the Act. These provisions require that Canadian taxpayers document non-arm's-length transactions with non-residents and use arms’-length transfer prices. Taxpayers are also required to update documentation for material changes and to provide the documentation to the CRA within 3 months of a request that is served personally or by registered or certified mail.

Section 247 allows the CRA to adjust a Canadian taxpayer's transfer prices or cost allocations where the transfer prices or cost allocations do not reflect arms’-length pricing.  Where the CRA has made a transfer pricing adjustment, the CRA can also impose penalties under section 247 in circumstances where a taxpayer has failed to make "reasonable efforts" to prepare and maintain contemporaneous documentation supporting transfer prices. Section 247 contains a provision that deems the taxpayer not to have made "reasonable efforts" to prepare and maintain contemporaneous documentation unless the taxpayer has compiled certain information and analysis.

Finally, paragraph 247(2)(b) of the Act provides the CRA with the power to "recharacterize" transactions in certain circumstances.

Transfer Pricing Audits

In Transfer Pricing Memorandum No. 5 ("TPM-05"), released in October 2004, the CRA officially set out what has been its practice with respect to audit requests for contemporaneous documentation. The CRA policy is that a CRA auditor must request contemporaneous documentation from the taxpayer at the initial taxpayer contact stage where the taxpayer has entered into transactions with non-arms’-length, non-residents or as soon as the existence of non-arms’-length transactions are identified during the course of an audit. Requests for contemporaneous documentation must be issued for each new audit cycle as well as each time any taxation year is added to an audit cycle. All requests must be in writing and either hand delivered to the taxpayer or sent by registered mail.

Where the taxpayer fails to provide the requested contemporaneous documentation to the auditor within three months of receipt of the request, TPM-05 notes that the taxpayer will be deemed not to have made reasonable efforts to document the transactions. The CRA states that it will not grant extensions of the three-month compliance period.

The CRA has also announced that it will be implementing an audit field strategy in support of Canadian Competent Authority. Expected benefits of implementing the strategy include:

• improved quality of transfer pricing documentation that is used to support Competent Authority negotiations;

• reduced time delays between acceptance of a Competent Authority request to completion of a position paper; and

• more consistency and predictability in the Competent Authority settlements.

Successful implementation of the field strategy by the CRA should benefit taxpayers generally in dealing with transfer pricing audits and more particularly in the event of a request for Competent Authority assistance. Competent Authority relies on the work papers and analysis prepared by the field auditor in the formulation of Canada 's position. Although additional information may be requested from the taxpayer by Competent Authority, the taxpayer's opportunity for input, once a file has been accepted by Competent Authority, is limited. Quality field audit documentation and economic analysis should assist the taxpayer's case.

Recharacterization and Penalty Provisions of the Act

Although the transfer pricing penalty and "recharacterization" provisions of the Act have been available to the CRA since 1998, it is only recently that audit proposals to assess using these provisions have been approved. In 1999, the CRA issued Information Circular 87-R2: International Transfer Pricing to provide taxpayers with guidance relating to its transfer pricing approach. In that document, the CRA stated that the circumstances in which "recharacterization," in particular, would apply would be limited. Statistics recently cited by CRA, however, may suggest that the CRA is moving towards the view that the "recharacterization" provision is a more powerful tool in the transfer pricing context either than CRA or taxpayers first thought.

Paragraph 247(2)(b) of the Act sets out the "recharacterization" powers of the CRA. Paragraph 247(2)(b) permits the CRA to "recharacterize" or alter non-arms’-length transactions of taxpayers in certain circumstances. The CRA can disregard the transaction that a taxpayer has undertaken and regard it as one that CRA believes the taxpayer would have undertaken had the taxpayer been acting on an arms’-length basis. This "recharacterization" can be undertaken only where:

• the transaction or series of transactions would not have been entered into between parties dealing at arms’-length, and

• it can reasonably be considered that the taxpayer's transaction or series of transactions was not entered into primarily for bona fide purposes other than to obtain a tax benefit.

Subsection 247(3) of the Act provides that a penalty of 10% may be imposed on a taxpayer where the CRA makes a transfer pricing adjustment. In determining whether the penalty should be applied or what the amount of the penalty should be, CRA is precluded from taking account of any transfer pricing adjustments that would decrease a taxpayer's income or increase a taxpayer's loss. In other words, only positive adjustments are considered for penalty purposes.

All audit proposals for "recharacterization" of transactions and imposition of penalties must be reviewed by the Transfer Pricing Review Committee ("TPRC"). The TPRC is an internal government review committee charged with ensuring that the law is applied fairly and consistently. Taxpayers are not permitted to make representations directly to the TPRC and the TPRC is not charged with resolving transfer pricing disputes.

The TPRC is comprised of the Director of International Tax Operations Division who acts as Chair of the Committee, the Director of Competent Authority Services Division, the Senior Economist of the International Tax Operations Division and/or the Senior Economist of the Competent Authority Services Division, the Manager of Field Advisory Services in the International Tax Operations Division, and a representative from the Department of Justice. The Chair of the Committee may also invite other persons to sit on the Committee from time to time as appropriate including representatives from the Audit Directorate and the Tax Avoidance and Special Audits.

As of September 28, 2004, the TPRC had reviewed 17 audit proposals for "recharacterization" or the imposition of penalties. The TPRC approved "recharacterization" in six cases, imposition of penalties in five cases and took no action in six other cases. In two of the five penalty cases, reassessments have been issued.

As soon as an auditor determines that either the penalty or "recharacterization" provision of section 247 of the Act may apply to a taxpayer's transactions, the auditor must seek assistance from the Field Advisory Service ("FAS") of the International Tax Directorate in Ottawa. In the case of "recharacterization," the TPRC will provide an opinion regarding whether the auditor should proceed with an in-depth examination of the transaction at issue. The auditor should advise the taxpayer that the CRA is considering "recharacterization" and request that the taxpayer provide all relevant information for consideration during the review. On completion of the audit, the auditor must formally submit the file to the FAS and the FAS will schedule a review by the TPRC. If the TPRC recommends "recharacterization," a proposal letter will be issued to the taxpayer and the taxpayer will be invited to make additional representations, through the auditor and the FAS, for TPRC consideration.

It is difficult to predict, at this point, whether the CRA will be successful in maintaining "recharacterization" and penalty assessments in court challenges by taxpayers. Demonstrating that a transaction would not have been entered into by parties dealing at arms’-length and was not entered into primarily for purposes other than to obtain a tax benefit may be difficult, particularly if the taxpayer has carefully documented the rationale for the non-arms’-length transaction. The CRA's success has been mixed in applying the general anti-avoidance provision of the Act, another provision that contains a similar bona fide purpose test.

Competent Authority – Strained Relations

and Mutual Agreement Procedures ("MAP")

As audits are finalized and assessments are raised by the CRA under Canada 's current transfer pricing regime, taxpayers are increasingly finding themselves in the position of having to decide whether to apply to Competent Authority for relief from double taxation or proceed to litigate assessments.

At the Competent Authority level and in the APA process, good relations between Canada and its treaty partners are critical to successful negotiations. There is some evidence that Canada 's relationships with revenue authorities of other countries, in particular the United States, are currently strained.  Some practitioners have noted a lack of willingness on the part of the CRA to be reasonable in negotiations, a reluctance to recognize the validity of positions of the other revenue authority and even a lack of good faith in negotiations. This development may lead to the use of litigation as the preferred dispute resolution mechanism.

The CRA has acknowledged that, in some cases, Canada has not been able to support transfer pricing adjustments at Competent Authority negotiations without performing additional functional and economic analysis because of field audit deficiencies. The Internal Revenue Service, in particular, believes that Canada should vacate audit adjustments where there is a lack of available audit documentation. Availability of audit documentation would seem to be critical to good relations with treaty partners, and in particular the United States, given that in the CRA's fiscal 2003-2004 year, 71% of  Competent Authority cases were Canadian-initiated and 81% of all cases that were completed in the 2001-2004 period were with the United States. Only 3% of cases were negotiated with the United Kingdom and negotiations with Japan accounted for 2.5% of all competed cases.

On the other hand, the CRA appears to recognize the importance of good relationships and of improved MAP in the context of international tax dispute resolution. The OECD has recommended that government authorities address taxpayer concerns regarding the lack of transparency in MAP and the lack of information with respect to MAP processes. The CRA has actively sought to address these issues by providing Canadian taxpayers with more detailed information relating to Competent Authority processes and procedures with the release of  Information Circular 71-17R5 on February 1, 2005. The draft information circular specifically deals with transfer pricing issues.

During the CRA's fiscal years 2001 through 2004, Canadian Competent Authority negotiated 119 cases involving transfer pricing issues. In 57% of the cases, taxpayers used either the comparable uncontrolled price ("CUP") or the cost plus transfer pricing methodologies ("TPMs"). Taxpayers utilized the transactional net margin method ("TMNN") in 24% of the cases; the profit split TPM in 11% of the cases and the resale minus method in 8% of the cases.

During the 2001 – 2004 period, Competent Authority cases involved a broad range of industrial corporations and service providers. Excluding Competent Authority requests from individuals, 11% of Canadian Competent Authority cases involved double taxation issues in the computer and electronics sector of the economy. Taxpayers in the health, metals and minerals, and auto and transportation sectors each accounted for 10% of the Competent Authority requests.

The CRA has also announced that it will implement the audit field strategy referenced above in support of Competent Authority and that it will try to adhere to the PATA target for resolution of double taxation issues. The PATA goal is for member tax administrators to conclude a mutual agreement with respect to double taxation issues within 24 months of receipt of a complete request from the taxpayer. The length of time required by Competent Authority to resolve double tax disputes has long been a concern of taxpayers and practitioners. Efforts to speed the process are welcome.

APAs

The CRA continues to promote its APA program as an alternative to Competent Authority dispute resolution. Successful negotiation of an APA can provide Canadian taxpayers with significant benefits including certainty that transfer pricing methods employed are accepted by the agreeing revenue authorities for future years and possibly prior years. During the CRA's fiscal 2003-2004 year, the CRA completed work on 17 APAs, the highest number in any year since the program's inception.

The CRA has published statistics and commented on the use of TPMs in the CRA APA Program Report 2003-2004. The statistics show that the predominant APA TPMs are profit-split and TNMM. These two TPMs have been used in over 60% of the completed and in-progress APAs since the program's inception. The CUP method, on the other hand, has been used only 17% of the time.

Canada considers that the profit-split methodology is to be preferred over TNMM when good quality comparables are unavailable because, in the CRA's view, profit-split more accurately reflects the arms’-length principle. In particular, the CRA prefers profit-split where the transactions at issue involve tangible transactions between parties that are highly integrated and when non-routine intangibles are involved. The CRA notes that nearly all APA transactions involving royalty payments are resolved using the profit-split method — either as the TPM or as a test to determine a reasonable rate.

With respect to TNMM profit level indicators, the preferred indicators are operating margin for transactions involving Canadian or foreign distributors that have not contributed to the creation or exploitation of valuable intangibles and total cost plus where Canadian or foreign manufacturers have not contributed to the creation or exploitation of valuable intangibles. The CRA prefers to use the Berry Ratio and return on assets profit level indicators as screening tools only. The CRA has, however, completed one APA using the Berry Ratio and two in-progress APAs employ this profit indicator. No APAs have been completed using return on assets as a profit indicator although two are in progress.

While the CRA statistics and comments relate to TPMs in the APA context, the statistics and comments may be instructive as to CRA preferences for the testing of taxpayer TPMs on audit.

As with Canadian Competent Authority cases, a substantial number of APAs are negotiated with the United States.  Approximately 80% of completed and in-progress, bi-lateral or multi-lateral APAs involve the United States while Japan and the United Kingdom account for 7% and 4%, respectively.  30% of completed and in-progress APAs have been requested by taxpayers in the automotive sector while 13% have been filed by taxpayers in the computer and electronics sector and 11% involve taxpayers in the metals and minerals sector.

In conjunction with the APA programs of member nations, PATA released two documents during 2004 designed to provide guidance to taxpayers regarding MAP procedures and bilateral APAs. Both documents are available to taxpayers on the CRA web site.

The CRA is also focusing on promoting APAs for small businesses that engage in non-arms’-length transactions. Small businesses are defined as those having revenues of less than $50 million in the most recent taxation year. Alternatively, a taxpayer will be eligible for the program if the transactions to be covered by the APA total less than $10 million. Small business APAs will apply to transactions involving tangible goods and routine services only. Taxpayers will be required to prepare a functional analysis but will not be required to prepare any economic analysis. The APAs secured under this program will be unilateral and not bilateral in nature and no "roll-back" of results to prior years will be permitted.

The CRA's web site (www.ccra-adrc.gc.ca) provides helpful information to taxpayers interested in pursuing an APA under the regular program or the small business program.

Some Litigation Trends

Information is a key commodity for the CRA in the transfer pricing context, particularly in circumstances where the taxpayer decides to contest an assessment in court. As a result, the CRA is demanding more information, domestic and foreign-based, on audit and is routinely serving "requirements" under sections 231.6 and 231.2 of the Act. The CRA can also secure information relating to third parties under section 231.2. If a requirement is issued and the taxpayer fails to comply within the requisite time period, the CRA may apply to a judge for a court order requiring production of the information. If the taxpayer fails to comply with the court order, section 231.7 of the Act allows a judge to find the taxpayer in contempt of court.  Where a requirement is served under section 231.6 and the taxpayer fails to comply, the taxpayer may be precluded from subsequently using the information in a legal proceeding.  The CRA is also aggressively demanding access to accounting working papers. The CRA considers that these working papers may provide relevant information regarding taxpayer transactions and tax positions.

During 2003, the Tax Court of Canada dealt with the issue of foreign based information in GlaxoSmithKline v. The Queen (2003 D.T.C. 918). The taxpayer had been served with a requirement to provide all studies and other documents comparing a particular drug component to the same component used by generic drug companies or to comparables on the open market. Glaxo produced one document on the basis that it was undesirable to produce the documents requested for reasons unrelated to the audit. While the court declined to issue an absolute prohibition on the use of documents covered by the requirement, it did restrict the use of the information by the company to rebuttal evidence or cross-examination and then only with leave of the trial judge. Procedural skirmishes continue to occur (The Queen v. Glaxo Smithkilne Inc. [2005 FCA 30]). A second case involving Hoffman-LaRoche is also in progress. Trial dates have yet to be set in these cases.

Cases currently before the courts indicate that the CRA has attacked cross border non-arms’-length transactions using a number of assessing strategies. Although all of the cases cited below involve transactions that took place prior to the enactment of Canada 's current transfer pricing legislation, they are nonetheless insightful. In some cases, the CRA has challenged transfer pricing using section 69 of the Act, the predecessor to section 247 of the Act. In other cases, the CRA has denied the deduction of amounts paid to non-resident, non-arms’-length parties under other provisions of the Act. In still other circumstances, the CRA has demonstrated a willingness to challenge or dismiss valuations of impugned non-arms’-length transactions or to utilize the provisions of the Excise Tax Act and reassess taxpayers for goods and services tax ("GST").

In Canada Safeway v. The Queen (Can T.C., 2003-2925 (IT)G), the CRA is relying on subsection 69(2) of the Act in the pre-1998 transfer pricing regime to deny the Canadian company a deduction for certain charges paid to a non-arms’-length US resident in computing income for the 1996 taxation year. The CRA has asserted the charges were unreasonable and that no arms’-length party would have agreed to pay the amount at issue. While the pre-1998 regime did not contain a requirement that Canadian taxpayers prepare contemporaneous documentation, the rules did impose an "arms’-length" standard consistent with that now embodied in section 247 of the Act.

A second case of interest is Norand Data Systems Ltd. v. The Queen (Can. T.C. No. 2003 – 3525(IT)G). In this case, the CRA is relying on more general provisions of the Act and Article 7 of the Canada – Untied States Tax Convention (1980) (the "Treaty") to deny the Canadian taxpayer a deduction for amount paid to a US resident, non-arms’-length party. This case is particularly interesting from two perspectives. First, the case raises transfer pricing issues in the context of a permanent establishment. As neither section 69 nor section 247 of the Act applies to permanent establishments or branches, the CRA must rely on other provisions of the Act and the Treaty to deal with transfer pricing issues. Second, the case involves an adjustment to a previously filed tax return and third-party prepared transfer pricing studies. The adjustment arose because the taxpayer subsequently determined that the transfer pricing method as originally applied did not yield an arms’-length result. Transfer pricing studies undertaken on behalf of the Norand Group showed that Norand Data Systems Ltd. had paid less than an arms’-length price for services provided by the company. The CRA appears to be taking the position that it is not prepared to accept transfer pricing adjustments resulting from the studies. Norand may serve to caution Canadian taxpayers that just because studies have been prepared by third party professionals does not mean that the CRA will accept or be satisfied with the results.

In a third case, World Corp. v. The Queen (2003 D.T.C. 951), the CRA attacked the valuation of commissions that the taxpayer assigned to a non-arms’-length non-resident. The case involved an assessment for withholding tax under Part XIII of the Act and the CRA argued that the independent third-party valuation obtained by the taxpayer was too low. While the CRA did not prevail in this case, World Corp., along with Safeway and Norand, illustrate that the CRA is prepared to utilize different approaches in attacking transactions depending on the facts and circumstances encountered during the course of audits.

Finally, taxpayers should note the decision in Ford Motor Company of Canada v. Ontario Municipal Retirement Board et al ("OMERS") (2004 D.T.C. 6224), a shareholder oppression case. While the decision is being appealed, the case provides insights into the types of complex evidence and extensive analysis that may be required in any court challenge involving section 247 of the Act.

Canada and Recent OECD Developments

During 2001 the OECD released a discussion draft dealing with the attribution of profits to a permanent establishment.  Discussion drafts relating to profit attribution to permanent establishments of banks and to global trading operations were released in 2003. The OECD intends to finalize all three drafts during 2005.

Since Canada is a member of OECD Working Party No. 6, which is responsible for the discussion drafts, it is likely that the final recommendations of the OECD will be implemented, in some form, in Canada. This may well require amendments to the Act and possibly amendments to some of Canada 's existing tax treaties to permit "arms’-length" allocations of notional amounts.