Canadian Transfer Pricing Overview

Presented by Tim Bloos – MNP LLP

Agenda

Overview of Transfer Pricing in Canada Sources of Law and Regulations

Related provisions in the Income Tax Act (Canada)

Disclosure of Cross-border Transactions in Canadian Tax Returns

Tax Returns and Cross-border Transactions

Application of the Arm’s Length Principle OECD Guidelines

Arm’s Length Principle and TP Methods

Qualifying Cost Contribution Arrangements (QCCA)

Intangible Property

Intra-Group Services (Management Fees)

Recharacterization of Transactions

Transfer Pricing Adjustments

Contemporaneous Documentation Requirement

TP Adjustments and Part XIII Withholding Tax

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Agenda (cont’d)

Controversy and Management of Transfer Pricing Audits

Competent Authority (CA) Procedures

Advance Pricing Arrangements (APA)

Canadian Court Cases

Questions?

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Overview of Transfer Pricing in Canada

Sources of Law and Regulations

Charging section 247 of Income Tax Act (Canada) or ITA

Information Circular 87-2R: CRA position on application of OECD guidelines

OECD guidelines form part of principles of Canadian regulations

Transfer pricing memoranda (TPMs) provide application principles of CRA for particular TP issues

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Related Provisions in the ITA (Canada)

Transfer pricing rules in section 247 of the ITA (formerly ss 69(2) of the ITA) intended to reflect OECD Guidelines: 247(1) Definitions

247(2) Recharacterization

247(3) Penalties and Adjustments, 247(10) Ministerial discretion

247(4) Reasonable efforts and contemporaneous documentation

Other provisions apply first if more specific: Section 17 (inadequate interest charged on loan to non-

resident)

Section 80.4 (receive interest free or no interest loan from non-resident)

Subsection 15(2)(shareholder debt)

Subsection 18(4) (thin capitalization) CHANGES IN BUDGET

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Disclosure of Cross-border Transactions in Canadian Tax Returns

Tax Returns and Cross-border Transactions

T106 Form must be completed each year and discloses transfer pricing transactions in which Canadian taxpayer participates, including: Sales and purchases from non-residents

Loans, advances, derivative transactions

Tangible and intangible property rents/royalties

Services fees

Management fees and cost reimbursements

Late filing fees from $25-$2,500 Total reportable transactions for each NR must be

greater than $1m to be disclosed

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Tax Returns (cont’d)

T1134 Form must be completed each year and discloses financial results and transactions with foreign affiliates of Canadian companies: Can identify cross-border transactions based on

questionnaire

Should be already disclosed in T106

Impact of TP adjustments would show up in this form

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Tax Returns (cont’d)

Schedule 29: payments to non-residents (identifies royalties, rents, management fees, technical fees, R&D, interest, dividends etc.) … ensure consistency with T106

Threshold is much lower than T106

Also includes payments to unrelated non-residents

Also, Schedule 5: earning income from multiple

jurisdictions … if there is income being earned from a source that is outside Canada ….

= does this indicate a potential PE in a foreign jurisdiction?

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Application of the Arm’s Length

Principle

OECD Guidelines

Canada closely endorses the OECD guidelines and principles supporting the arm’s length principle as the basic rule governing taxation of non-arm’s length transactions Groups of related parties treated as if separate

entities

Comparison of “controlled transaction” (prices or margins between NAL parties on cross-border transactions) with “uncontrolled transaction” (similar transactions with arm’s length parties)

Determined on a case by case basis

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Arm’s Length Principle and TP Methods

Arm’s length principle Terms and conditions agreed between non-arm’s length

parties be those that would expect if were dealing at arm’s length… such that any profits that would otherwise have accrued would be included and taxed… (OECD Model Tax Convention Art. 9)

Comparison or benchmarking of prices/margins of arm’s length parties engaged in similar transactions

Number of factors influence degree of comparability of transactions including business strategy

Taxpayer must exercise judgement in assessing comparability and choosing best method in light of facts and circumstances

Sometimes necessary to bundle or unbundle transactions in order to properly compare and benchmark

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Arm’s Length Principle and TP Methods (cont’d)

TP Methods (OECD Guidelines) ITA does NOT outline heirarchy of methods nor does it

mandate specific methods but CRA’s view is that there is a natural heirarchy based on reliability and depending on degree of comparability

Two groups of methods: Traditional transaction methods CUP (comparable uncontrolled price)

Resale price

Cost plus

Transactional profit methods Profit split

TNMM (transaction net margin method)

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Comparison of Methods (cont’d) Reliabiity of any method is a function of:

Availability of data

Degree of accuracy with which can make adjustments to achieve comparability between controlled and uncontrolled transactions Comparability between controlled and uncontrolled is a function of:

Existence or absence of material differences

And, whether reliable adjustments can mitigate or eliminate the differences

Arm’s Length Principle and TP Methods (cont’d)

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Commentary on methods: Traditional Transaction Methods

CUP method = best evidence of arm’s length price

Resale price method = best method where seller adds little value to the income earning process

Resale price/cost plus methods are applied to one party, best applied where functions performed are less complex and intangible property not involved

Transactional Profit Methods Most reliable but, most difficult to find reliable comparables

Profit split method applied to two members

TNMM to one, based on a comparison of net margins

Arm’s Length Principle and TP Methods (cont’d)

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Arm’s Length Principle and TP Methods (cont’d)

OECD direction: Remove distinction between traditional (CUP, resale price, cost

plus) and profit-based methods (TNMM, profit split) unless are equally reliable then prefer CUP

New heirarchy based on finding “most appropriate method”

Higher standards of comparability for profit-based methods

Higher standards of comparability and more scope for use of data analysis (adjustments, statistical methods) … with nine step process added

More importance of TNMM – selection of profit level indicators (PLIs) such as return on sales/capital/cost

Likely increase in use of profit split methods

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Qualifying Cost Contribution Arrangements (QCCA)

Subsection 247(1) of ITA defines as: arrangement, 2 or more parties share costs and risks of producing, developing or acquiring property/services in proportion to benefits each reasonably expected to derive Individual benefit measured by share of profits from

exploitation and NOT from actual activities performed in QCCA

Typically used for: multiparty development of IP or shared centralized services

Each contribution must be consistent with what an arm’s length contribution would be given the benefit to be derived (must derive a benefit to be a participant in QCCA) … otherwise a balancing payment may be required

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QCCA (cont’d)

FMV of contribution must = proportion of benefit to be derived

Benefits derived are measured by income generated or cost savings expected to realize from QCCA Allocation keys (sales, profit, capital invested) used to estimate

apportionment of income to participants

SR&ED carried out as part of contribution is calculated before any incentives or subsidies are applied

Participants transferring value of previous development to QCCA must receive FMV for “buy-in payment”

Participants disposing of share of QCCA must receive FMV for “buy out payment”

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Intangible Property (IP)

Specific issues in applying arm’s length principle where there is intangible property involved Transfer of intangible property Value to both transferor

and transferee must be taken into consideration … key consideration is overall expected benefit to recipient of IP = willing to pay

Valuation of IP (sale or license) Difficulties because of inherent risk with future value, but most often much more valuable that book value/cost CUP or resale price method most appropriate but

comparability will be an issue

TNMM likely not appropriate for IP that is highly valuable or unique

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Intangible Property (cont’d)

Where valuation in a sale or license of IP is uncertain an arm’s length transferor and transferee may consider: A shorter term license

A price adjustment clause for a sale

Variable royalty or buyout rates based on profits

Factors in establishing an arm’s length royalty rate: Prevailing rates for industry

Limitations based on geography, time, exclusivity

Uniqueness of invention and expected lifespan of “uniqueness”

Technical assistance, trademarks, know how and patents associated with the IP

Profits to licensee and non-monetary benefits to licensor

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Intangible Property (cont’d)

Marketing intangibles Taxpayer undertakes marketing activities associated with a

tradename or trademark that it does NOT own

Reasonable to share in some return attributable to these marketing intangibles

Distributors or local service providers providing marketing activities that may or may not go beyond those that an arm’s length party would incur given expected returns

Should be compensated with additional returns

Look at actual marketing activities undertaken by a distributor over period of time should be given weight in evaluating return on marketing activities

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Intangible Property (cont’d)

Use of hindsight in valuing intangibles NOT appropriate to use hindsight in determining a transfer

price for intangibles

As long as original agreement entered into would be one which arm’s length parties would have entered into

CRA cannot use hindsight or subsequent events to adjust TP values on basis that they differed from what was initially intended

May try to argue that subsequent events should have been considered by a reasonable person at time of entering into arrangement

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Intangible Property (cont’d)

CRA will review the following transactions involving transfer prices and intangibles based on OECD guidelines: Sale of IP under a long term contract

involving a lump sum payment and

where there is unlimited entitlement to the IP based on future research

CRA will review transactions with these characteristics to ensure consistent with arm’s length principle or attempt to recharacterize under 247(2)

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Intra-Group Services (Management Fees)

Routine focus of CRA audits

Issues under OECD guidelines: 1. Has a service been rendered?

Direct services (not usually an issue)

Indirect services (impact multiple group companies)

2. Is the charge for the service arm’s length?

Documentation required: Nature of services provided

Benefit provided to Canadian entity

Breakdown of costs/categories (stewardship costs)

Basis of allocation of costs among entities

Arm’s length support for any markup over cost

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Recharacterization of Transactions

Unique aspect of Canadian TP regime is express power to recharacterize transactions under 247(2)(b) Where arm’s length persons would not have entered into

transaction; and

It was entered into primarily to obtain a tax benefit (which includes a benefit arising from the application of a tax treaty)

Where CRA proposes to recharacterize a transaction under this provision, it must, first, refer the matter to an internal Transfer Pricing Committee (TPRC) CRA sees unbundling and assigning TP values to

unbundled elements NOT the same as recharacterization

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Transfer Pricing Adjustments - Penalties

Subsection 247(3) renders penalty if net result of certain adjustments made under 247(2) in a year exceeds the lesser of 10% of taxpayer’s gross revenue for the year and $5m Where threshold is breached, penalty applies to full

amount of the adjustment (not just amount of threshold)

Adjustment that is subject to penalty is: Reduced for upward adjustments - 247(4) compliant

Increased for downward adjustments - 247(4) not compliant

CRA must refer penalty application to review committee (TPRC)

Other penalties: failure to withhold tax, underestimation of installment base and improper filing of T106

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Transfer Pricing Adjustments - Types

Primary adjustments (TPM-03) Cannot be unilaterally proposed by taxpayer by filing

amended return, at discretion of MNR only

Upward adjustments (increase in income/decrease in loss or capital expenditure)

Downward adjustments (decrease in income/increase in loss or capital expenditures)

Secondary adjustments is essentially the constructive transaction that implements the re-allocation of profits from the primary adjustment (ie. by way of constructive dividend, equity contribution or loan) BUDGET CHANGE Will be effected by way of deemed

dividend so could have Part XIII wht implications

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TP Adjustments: Other Tax Consequences

Section 247 adjustments could lead to a variety of non-TP consequences for the Canadian taxpayer including: Imputation of FAPI (foreign accrual property income) to a

Canadian shareholder for certain income earned by a Canadian foreign affiliate

Application of GAAR (anti avoidance rule) to qualifying aggressive tax plans

Methods for determining transfer prices resemble methods for determining dutiable value under Customs Act but not same CRA NOT required to accept dutiable value when considering

transfer price on non-arm’s length transaction

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Contemporaneous Documentation Requirement

Reasonable efforts to determine and use arm’s length prices and allocations 247(3) penalty assessed when net TP adjustment exceeds

threshold unless reasonable efforts demonstrated (not function of accuracy of TPs)

247(4) deems reasonable efforts when taxpayer has prepared or obtained records which meet specified requirements by documentation due date and provided them within 3 months of a request from CRA Documentation due date is 6 months after tax year end

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Contemporaneous Documentation (cont’d)

Documentation: Property or services which are subject of transaction

Terms/conditions of the transaction and relationships/identity

Functions performed/property used or contributed and risks assummed

Data/methods considered and analysis to determine prices and allocations of profits/losses or contributions to costs

Assumptions, strategies and policies that influenced determination of above

Obligation of taxpayer: Update annually by documentation due date

Change analysis as facts and circumstances change

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TP Adjustments and Part XIII Withholding Tax

Adjustments under 247(2) may give rise to withholding tax on the amount of the adjustment as a deemed dividend under 214(3)(a) of ITA Excess amounts paid for the purchase of property, the

payment of royalties, management fees etc.

CRA may grant relief from withholding taxes when: Taxpayer agrees in writing to adjustments, and

Adjustments not arise from a transaction that was abusive

Foreign entity agrees to repatriate adjustment amounts within reasonable time

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Controversy and Management of

Transfer Pricing

Audits

Last 5-6 years, CRA has significantly stepped up auditing of TP documentation and become very aggressive in reviewing T106 disclosures Management fees versus cost reimbursement

Allocation of profits to Canadian branches

Interest rates on intercompany cross-border loans

Cross-border transactions where there are intangibles involved particularly where there are issues of who owns and develops the intangible

CRA can reassesss a transfer pricing transaction up to 7 years after date of original assessment subject to a shortened period in the relevant tax treaty

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Competent Authority (CA) Procedures

Procedure for prevention of double taxation under treaties Most Canadian treaties based on model OECD Article 9

Framework where adjustments to profits by one country tax administration is offset by corresponding adjustments to profits by other country tax administration

Must notify applicable CA within treaty time limits

Cdn taxpayer must seek CA assistance before:

Making claims for corresponding adjustments in current Canadian income tax returns; or

Filing amending income tax returns

Taxpayer may request CA consideration under Mutual Agreement Procedure (MAP) (IC 71-17R5)

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Competent Authority (cont’d)

Scope of Competent Authority consideration: NOT negotiate the right to apply transfer pricing penalty but

will adjust the penalties in accordance with changes to adjustments arising from CA negotiations (application of penalty not covered under MAP)

NOT challenge foreign tax authority on their application of transfer pricing penalties

ONLY deal with avoiding or minimizing double taxation arising from income or capital adjustments

NOT enter into CA negotiations where there has been fraud, wilful default or gross negligence by the taxpayer

CRA can only negotiate with foreign tax authorities what has been properly documented by the taxpayer

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Competent Authority (cont’d)

Accelerated Competent Authority Procedure (ACAP) Outlined in IC 71-17R5

Expect to see sharp increase in use of ACAP procedure

Request as part of CA procedure to have subsequent unaudited tax years covered on the same issue

Alleviates burden of a separate audit and MAP process

Waiver of Interest Taxpayers can obtain a waiver of interest that accumulates

while file is in the MAP process

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Advance Pricing Arrangements (APA)

APA is an agreement/arrangement between a taxpayer and CRA stipulating a mutually acceptable transfer pricing methodology to be used on specific transactions for a specified future period (IC 94-4R) No legal requirement to enter into APAs (better management)

10 step process, can take up to 3 or 4 years, avg. 2.5 years

APA “rollback” available for prior but open taxation years where there is no outstanding Cont. Docn. requests

Bilateral is agreement by two jurisdictions (multilateral, more than two) on methodology and specified transactions/period so as to avoid double taxation

= No 247(2) adjustments as long as APA in effect and taxpayer complies with terms & conditions …. so penalty provisions cannot apply either

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APA (cont’d)

APAs can be unilateral between Cdn taxpayer and the CRA but a rollback is not available in this context and there is no guarantee against double taxation like with bilateral and multilateral APAs

APAs for Small Businesses IC 94-4RSR

More cost effective than producing documentation for each year

More streamlined process

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Canadian Court Cases

Most court decisions have dealt with previous TP provision ss.69(2) and not 247

Many court cases dealing with procedural and evidentiary issues in TP context: admissability of evidence and discovery

examinations (Cameco (2010) TCC)); and

testimony of expert witnesses (GE Capital (2009) TCC)

CRA seen to be attacking taxpayers in court on transfer pricing issues using procedural weapons both prior to and at TCC

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Canadian Court Cases (cont’d)

Court decisions on substantive TP issues: GlaxoSmithKline Inc. (2010) FCA - Comparability of

generic CUPs for Zantac, failure to take real business circumstances into consideration in looking at comparability

GE Capital (2009) TCC /(2010) FCA – Methodology for pricing parent-subsidiary guarantee fees

Alberta Printed Circuits Ltd. (2011) TCC – Quantifying services for software, website development and maintenance

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Questions?

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