Taxing authority and tax law

Tax authority: The Canada Revenue Agency (CRA) is responsible for ensuring that taxpayers meet the requirements of the law.

Tax law: Section 247 of the Income Tax Act (Canada) (ITA) received Royal Assent on 18 June 1998 and became generally applicable to taxation years that began after 1997. It constitutes Canada’s transfer pricing legislation and deals with the determination of transfer pricing adjustments, the re-characterization of transactions, penalties, records/documents required to be made or obtained, contemporaneous documentation requirements and the timing of their provision to the Minister when requested, as well as ministerial discretion regarding acceptance of downward adjustment requests.

Relevant regulations and rulings

The CRA does not set out its views and positions on transfer pricing issues by legal doctrine or in a detailed fashion or examples. The CRA prefers to outline its views in general principles.

It provides its administrative interpretations and guidance with respect to §247 and its application through the release of Information Circulars (IC), Transfer Pricing Memoranda (TPM) and pronouncements at public conferences, symposia and conventions. ICs usually address major subjects from a general perspective, while TPMs typically provide supplementary detailed explanations and guidance on specific issues related to the major subject.

CRA’s current key pronouncements on transfer pricing are:

• IC87-2R, International Transfer Pricing, 27 September 1999
• IC94-4R, International Transfer Pricing: Advance Pricing Arrangements (APAs), 16 March 2001
• IC94-4R (Special Release), Advance Pricing Arrangements for Small Businesses, 18 March 2005
• IC71-17R5, Guidance on Competent Authority Assistance Under Canada’s Tax Conventions, 1 January 2005

The CRA issued TPM 12 on 12 December 2008, providing formal guidance regarding the Accelerated Competent Authority Procedure (ACAP). Taxpayers may request assistance for subsequent assessed (but unaudited) taxation years on the same issues included in a mutual agreement procedure (MAP) process. The main objective of the ACAP is to streamline certain steps in the MAP process, such as being able to simultaneously negotiate with the foreign competent authority for both MAP and ACAP years.

Additional information and guidance on transfer pricing-related matters can be obtained from the CRA’s website (www.cra-arc.gc.ca/tx/nnrsdnts/cmmn/trns/menu-eng.html)

OECD guidelines treatment

While no mention is made of the OECD guidelines in §247 of the ITA, the legislative provision is intended to reflect the arm’s-length principle as set out in the OECD guidelines. The CRA has also endeavored to harmonize its administrative guidance and approach to transfer pricing with the OECD guidelines. As noted in IC 87-2R, the “circular sets out the Department’s views on transfer pricing and also provides the Department’s position with respect to the application of the OECD guidelines.”

When dealing with transfer pricing issues domestically, reliance is placed on the relevant Canadian statutory provisions. The CRA’s related ICs and other administrative guidance are considered instructive but not definitive. Moreover, the OECD guidelines and other OECD reports are not usually recognized as authoritative; however, courts and other dispute resolution channels (e.g., competent authority) may consider the international principles and standards established by the OECD in reaching a decision.

Priorities/pricing methods

The CRA accepts the transfer pricing methods recommended in the OECD guidelines when such methods are applied correctly and result in an arm’s length price or allocation. These transfer pricing methods specified in IC 87-2 include

• CUP method
• Resale Price method
• Cost Plus method
• Profit Split method (residual/contribution)
• TNMM

However, the CRA considers the use of the Profit Split method as a method of last resort.

Traditionally, the CRA considered that, notwithstanding that §247 does not so stipulate, there is a natural hierarchy in the application of the above-noted transfer pricing methods, with the CUP method providing the most reliable indication of an arm’s length transfer price or allocation and the Profit Split method providing the least reliable indication of an arm’s length result. Traditionally the CRA did not require or impose a “best method” rule. The CRA believes that the most appropriate method to be used in any situation will be that which provides the highest degree of comparability between transactions, following an analysis of the hierarchy of methods. The Tax Court of Canada, in the 2008 Glaxo case, has embraced the hierarchy of methods as outlined in the 1995 OECD Guidelines.

Following the 2010 revisions to the OECD guidelines, which CRA has endorsed, it is understood that the CRA will be updating its published guidance to reflect the revisions, moving away from its position on a natural hierarchy. Timing for these updates remains uncertain.

Transfer pricing penalties

Subsection 247(3) of the ITA causes a taxpayer to be liable for a penalty of 10% of the net upward transfer pricing adjustments made under subsection 247(2) of the ITA, if such adjustments exceed the lesser of 10% of the taxpayer’s gross revenue for the year and CA$ 5m, and if the taxpayer has not made reasonable efforts to determine and use arm’s length transfer prices.

A taxpayer will be deemed not to have made reasonable efforts to determine and use arm’s length transfer prices or allocations unless the taxpayer has prepared or obtained records or documents that provide a description that is complete and accurate in all material respects of the items listed in subsection 247(4) of the ITA, and such documentation is in existence as of the tax filing due date. In the case of corporate entities, such documentation must exist six months after the year-end. For partnerships, the due date is five months after the year-end. Further, a taxpayer will be deemed not to have made reasonable efforts to determine and use arm’s length transfer prices or allocations if the taxpayer does not provide the records or documents to the CRA within three months of the issuance of a written request to do so.

Transfer pricing related penalties are exacted without reference to the taxpayer’s income or loss for the relevant reporting year and are not tax deductible.

Penalty relief

If a taxpayer is considered to have made reasonable efforts to determine and use arm’s length transfer prices or allocations with respect to adjusted non-arm’s length transactions, no penalty would be applicable to such adjustments.

As set out in by TPM-07, all proposed reassessments involving transfer pricing penalties are required to be referred to the Transfer Pricing Review Committee (TPRC) for review and recommendation for final action. The TPRC, after consideration of the facts and circumstances and representations by the relevant taxpayer, will conclude whether or not a transfer pricing penalty is justified.

No transfer pricing adjustments under subsection 247(2) of the ITA should arise regarding transactions covered by an APA as long as the APA remains in effect and the taxpayer complies with its terms and conditions.

When the CRA has reassessed a transfer pricing penalty and the Canadian competent authority and relevant foreign counterpart negotiate a change to the amount of the transfer pricing adjustment, the CRA will adjust the amount of the Canadian transfer pricing penalty accordingly. If the result of the change is that the adjustment no longer exceeds the penalty threshold, the penalty would be rescinded.

Documentation requirements

Subsection 247(4) of the ITA requires that a taxpayer must have records or documents, as a minimum, that provide a complete and accurate description, in all material respects, of the following items:

• The property or services to which the transaction relates
• The terms and conditions of the transaction and their relationship, if any, to the terms and conditions of each other transaction entered into between the persons or partnerships involved in the transaction
• The identity of the persons or partnerships involved in the transaction, and their relationship at the time the transaction was entered into
• The functions performed, the property used or contributed and the risks assumed by the persons or partnerships involved in the transaction
• The data and methods considered and the analysis performed to determine the transfer prices, the allocations of profits or losses, or contributions to costs for the transaction
• The assumptions, strategies and policies, if any, that influenced the determination of the transfer prices, the allocations of profits or losses, or contributions to costs for the transaction

In addition, although its views are not law, the CRA indicates in IC 87-2R that it expects a taxpayer’s documentation to include certain additional information (e.g., details of cost contribution arrangements, translations of foreign documents and other general guidance).

The CRA issued TPM 09 on 18 September 2006. The purpose of this memo was to define the meaning of “reasonable efforts” under §247 of the Act. In practice, TPM 09 has not significantly enhanced clarity with respect to the reasonable efforts standard and, thereby, the potential application of transfer pricing penalties.

Documentation deadlines

Taxpayers must prepare or obtain records and documents that provide a description that is complete and accurate in all material respects of the items listed in subsection 247(4) of the ITA, and such documentation must be in existence as of the tax filing due date. In the case of corporate entities, such documentation must exist six months after the year-end. For partnerships, the due date is five months after the year-end.

Taxpayers must provide documentation to the CRA within three months of the issuance of a written request.

Statute of limitations on transfer pricing assessments

Under subsection 152(4) of the ITA, the Minister may not ordinarily reassess after the normal reassessment period as defined in subsection 152(3.1) of the ITA. For most multinational taxpayers, that period is four years beginning after the earlier of the day of mailing a notice of an original assessment for the year and the mailing of an original notification that no tax is payable for the year. The time limit applies unless the taxpayer has made misrepresentations, committed a fraud or filed a waiver, in which case the Minister may reassess a taxpayer at any time. Where a Notice of Reassessment is issued at a later date, the first assessment notice is still viewed as the original assessment for the purposes of determining the normal reassessment period under subsection 152(3.1) of the ITA. With respect to transactions involving non-arm’s length dealings with non-residents, the reassessment period is extended an additional three years to seven years. This time period may be further extended if the taxpayer provides the CRA with a waiver (i.e., authorization by the taxpayer to the CRA to waive the normal reassessment period). As of March 2009 a waiver may be provided by the taxpayer within the seven - year extended reassessment period. Previously, waivers were only allowed to be filed within the four - year normal reassessment period.

Return disclosures/related-party disclosures

Taxpayers are required to file a T106 information return annually, reporting the transactions undertaken with non-arm’s length non-residents during the taxation year. The T106 is a separate information return but is usually filed together with the corporate tax return. Data from the T106 is entered into a CRA database and is used to screen taxpayers for international tax audits.

Audit risk/transfer pricing scrutiny

The CRA continues to receive additional funding for its audit of international activities and to focus its audit resources on the examination of international transactions, especially transfer pricing.

The risk of a transfer pricing audit in Canada is high. Canadian companies with cross-border transactions with related parties can expect a request from the CRA for their required transfer pricing documentation prior to or during the course of an audit. As noted in TPM-05, “Contemporaneous Documentation,” effective October 2004, it is mandatory for field auditors to issue a formal written request to taxpayers for their transfer pricing documentation upon commencement of the audit or when cross-border non-arm’s length transactions with non-residents are identified during the course of an audit.

APA opportunity

The CRA launched its APA program in July 1993. As set out in IC94-4R, it offers taxpayers the opportunity to pursue unilateral, bilateral or multilateral APAs. In addition, the CRA has made a small business APA program available to Canadian taxpayers under certain conditions. The CRA charges taxpayers only travel costs it incurs in the completion of an APA.

On 20 August 2008, the CRA issued TPM 11, which discussed the CRA policy with respect to rolling an APA back to prior years. The main limitation imposed by TPM 11 is that APAs may not be rolled back to years for which a request for contemporaneous documentation under §247 has been issued. Effectively, this means that APAs cannot be rolled back to taxation years under transfer pricing audit.

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