TRANSFER-PRICING ISSUES ARE MANY SHADES OF GRAY, WHICH PRESENTS CHALLENGES FOR THE TAX PRACTITIONER AND THE TAXPAYER
Transfer pricing focuses on the pricing of goods, property, services, loans and lease transactions between multinational enterprises, and it's widely recognized that it is an art rather than an exact science. Transfer pricing and the application of the arm's-length principle requires understanding a taxpayer's unique facts and circumstances, interpreting comparable information and applying judgment to determine appropriate terms and conditions for intercompany transactions. Typically there is no black or white, but many shades of gray. This, coupled with the fact that current Canadian legislative and administrative guidance on many transfer-pricing issues is unclear, presents challenges for both tax practitioners and taxpayers.
Canada's Income Tax Act was amended in 1998 with the introduction of section 247, which requires that, effective for taxation years commencing after 1997, taxpayers must determine and use arm's-length terms and conditions for transactions with related parties or potentially face adjustments by the Canada Revenue Agency (CRA). For taxation years commencing after 1998, penalties may also be applied. Paragraph 247(2)(b) allows the CRA to recharacterize certain related-party transactions that would not ordinarily occur between arm's-length parties.
The tax act does not provide details on how arm'slength terms and conditions should be established; consequently, the CRA has provided some administrative guidance on its interpretation of the act's requirements through its Information Circular on International Transfer Pricing (IC 87-2R) issued September 1999. IC 87-2R outlined the agency's general views as to how the transfer-pricing provisions of the act would be applied in practice. While IC 87-2R did provide some further information, many transfer-pricing matters are discussed in broad concepts, leaving room for differing interpretations.
Following the issuance of IC 87-2R, the CRA has provided further guidance on transfer-pricing matters in its Transfer Pricing Memoranda (TPM), which are meant to supplement IC 87-2R and provide further guidance on specific aspects of the transfer-pricing legislation. To date, five TPMs have been issued covering very specific and technical aspects of the transfer-pricing legislation and administrative matters. However, TPMs have yet to deal with the more key transfer-pricing issues.
In September 2002, at the Canadian Tax Foundation Conference, the chief economist of the CRA's International Tax Directorate presented a somewhat controversial paper providing guidance on the CRA's approach to the use of ranges in testing a taxpayer's compliance with the arm'slength principle. Among other matters, the paper concluded:
* The CRA does not believe the use of statistical tools enhances the reliability of comparable data in the range.
* The CRA prefers the selection and use of specific comparables from the range that has a relatively high degree of comparability with the targeted transaction's key economic characteristics. (In practice, this criterion has often led the CRA to seek a small number of comparables and sometimes identify a single comparable when making transfer-pricing adjustments.)
* Where more than two comparables are relevant, the mean is a more relevant statistic than the median, as it incorporates all the range results.
* Multiple-year data is to be used only in selecting comparables and in making adjustments to potential comparables. However, as a taxpayer must determine his or her income on an annual basis, the transfer prices employed should be tested on the basis of the single-year results alone. (In practice, this can lead to year-by-year adjustments even when the taxpayer's results were within the range over the audit period taken as a whole.)
The courts may have to provide ultimate clarification on these matters. In the interim, tax practitioners and taxpayers must consider the CRA's stated position.
The CRA has become more aggressive in its enforcement and is willing to utilize its arsenal of tools to ensure taxpayers comply with the transfer-pricing rules. All taxpayers must be prepared to deal with transfer-pricing audits.
Every taxpayer dealing with related nonresidents can expect a more aggressive approach in CRA's transfer-pricing audits. Actions by the CRA to ensure compliance with section 247 include:
* A CRA internal directive instructing field auditors to formally request taxpayers' contemporaneous transfer-pricing documentation at the beginning of every audit.
* Increasing use of formal demands for information relating to transactions with nonresidents under sections 231.2 and/or 231.6 of the Income Tax Act.
Previously, some tax services offices of the CRA were using standardized letters when requesting documentation, while others were making informal requests or were not requesting the documentation at all. In October 2004, the CRA adopted a formal policy and instructed its auditors to formally request that each taxpayer provide contemporaneous transfer-pricing documentation at the initial stage of every audit. (The directive, dated October 13, 2004, can be found at www.craarc.gc.ca/tax/nonresidents/business/memorandums-e.html as Transfer Pricing Memorandum TPM-05.) Unlike general audit queries issued by the CRA, no extension of this statutory three-month period would be granted without penalties.
Previously, formal demands for information under sections 231.2 and/or 231.6 of the act had only been made as a last resort. Such demands often strain the relationship between the CRA and the taxpayer and any cooperative efforts in relation to the audit generally disappear once a demand has been made. Nonetheless, the CRA appears to be taking advantage of all enforcement tools available under the act.
The CRA has been taking an increasingly hardline approach to transfer-pricing documentation compliance and related penalties. Transfer-pricing audits are being conducted in smaller companies ($15 million in revenue) as well as multimillion-dollar companies. In fact, a CRA official confirmed, the first transfer-pricing penalty assessed by the CRA involved a transfer-pricing adjustment that exceeded the 10% of gross revenue threshold, indicating the taxpayer was a small company.
The CRA's Transfer Pricing Review Committee was formed in late 2003 to advise the local tax services offices on whether the 10% transfer-pricing penalty should be applied on adjustments in excess of $5 million or 10% of revenue because the reasonable efforts requirements of the act hadn't been met. All cases where transfer-pricing income or capital adjustments exceed these thresholds must be referred to the committee. It also advises tax services offices whether the form of transactions should be disregarded and recharacterized for transfer-pricing purposes pursuant to paragraph 247(2)(b) of the act.
Of the cases that have been referred to the committee for review, penalties have been applied in almost half the cases.
Given the current Canadian environment, taxpayers must be proactive when it comes to transfer pricing to ensure they are compliant. They should review their transfer-pricing documentation to ensure it is up-to-date and satisfies the information required under subsection 247(4) of the act. The transfer-pricing analysis must be robust enough to meet the more aggressive environment and to avoid penalties.
To gain greater certainty, taxpayers may consider participating in the CRA's advance-pricing arrangement (APA) program. This is a service that confirms the appropriate transfer-pricing methodology to establish an arm's-length price for specified crossborder transactions between related parties. An APA may be used to cover the selected transactions for up to five years. Therefore, the benefit of such an arrangement is that it provides certainty on the Canadian tax treatment of the covered intercompany transactions.
For smaller businesses, the CRA recently introduced special procedures to give them access to the APA program. The small business APA program (to be eligible, the taxpayer must have gross revenue of less than $50 million or a proposed covered transaction of less than $10 million) is designed to address small business taxpayers' concerns and to reduce time and costs.
Transfer pricing is not just a tax compliance matter. Taking a proactive approach also presents opportunities for taxpayers to incorporate transfer pricing into their tax planning. In today's environment, as multinational enterprises change their global operating models, fundamental changes to the business model (e.g., reorganization, M&As) may affect the pattern of intercompany transactions. This creates a need to regularly review transfer-pricing practices and policies. A failure to adjust transfer-pricing practices following major business changes may leave a multinational enterprise exposed to transfer-pricing adjustments and legitimate planning opportunities may be missed.
The CRA is becoming more aggressive in its transfer-pricing audit approach, taking an increasingly hard line on transferpricing compliance and related penalties. Now more than ever, strong transferpricing documentation is essential to avoid potential adjustments and penalties.
[Author Affiliation]
Sheila Smith, CA, is a partner working in the Toronto and Calgary offices of Ernst & Young LLP. Paula Kelley, CA, is a principal at Ernst & Young LLP in Toronto
Technical editor: Trent Henry, partner, Ernst & Young LLP
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