In Canada, transfer pricing rules are governed by a variety of rules, including Section 247 of the Income Tax Act. These rules are based on the international ‘arm’s length’ standard and the OECD Guidelines. In addition, Canada has a vast treaty network of 94 double tax treaties, most of which are based on the OECD Model Tax Convention on Income and Capital. Article 9 of those treaties addresses transfer pricing, and ties into the arm’s-length principle.
Taxpayer-created legal rights and obligations
Taxpayers have a variety of legal rights and obligations in the context of transfer pricing in Canada. These can vary depending on the nature of the transaction. In some cases, a taxpayer may want to seek prior approval before a transaction or may prefer to use an APA or ruling. In other cases, the taxpayer may disagree with the tax authorities in Canada or in the foreign country, and in these cases, there are several methods for resolving the dispute.
One way to resolve a transfer pricing dispute is to enter into an ITA with the CRA. ITAs allow taxpayers and the CRA to come to a consensus on the transfer pricing methodology used. Once an ITA is signed, the taxpayer is legally bound to adhere to it for three to five years. However, if the taxpayer is not satisfied with the transfer pricing methods used, it may request an adjustment.
Taxpayers are also required to provide a complete transfer pricing documentation package when filing their tax returns in Canada. If they fail to do so, penalties may result. A transfer pricing penalty can be significant, even substantial, and can be difficult to soften.
The BEPS Action Plan aims to create a united response to the problem of profit shifting and base erosion. Among its other objectives, it aims to improve transparency and substance in tax administration. This is one of the most significant pieces of legislation to have been passed in recent years, and taxpayers should pay close attention to it. If the new legislation goes into effect, taxing authorities may be more aggressive, especially when raising audits.
International ‘arm’s-length’ standard
The arm’s length principle lays out the terms and conditions under which uncontrolled enterprises deal with one another. Generally, arm’s length conditions are those in which the price or profit margin of the two parties are identical. This principle applies both to transactions within MNE groups and to those between unrelated parties. Accordingly, the arm’s length principle must be respected in all related party transactions under Canadian transfer pricing regulations.
Canada has a vast treaty network, including 94 double tax treaties, which align its transfer pricing rules with the international arm’s-length standard. Most of these treaties are based on the OECD Model Tax Convention on Income and Capital. The arms-length principle is a key part of the Canadian tax code and is applied by the Canadian Revenue Agency to determine the fair value of cross-border transactions.
However, courts have not always been consistent in which version of the OECD Guidelines to consult. Currently, the Commentary on the OECD Model Tax Convention on Income and Capital has been used by the courts in various tax treaties. While recourse to the various OECD Guidelines may be justified, it should not be relied on for evaluating arm’s-length pricing.
The Marzen decision has emphasized the fundamental principles of transfer pricing. It also highlights the importance of identifying the relevant substantive business activities. Furthermore, it highlights the fact that a transfer of intangible property does not transfer substantive people functions. Thus, a company’s transfer pricing policy should not be affected if the intangibles are transferred to another company through a transaction.
The Canadian Revenue Agency has the power to adjust a taxpayer’s transfer prices if it does not follow the arm’s-length principle. In case of non-compliance, the Canadian Revenue Agency may levy a transfer pricing penalty equal to 10% of the adjustments it made under the Income Tax Act.
CRA’s reasonable effort standard
The CRA’s reasonable effort standard for transfer price is an important part of tax law. It requires taxpayers to substantiate their transfer prices using contemporaneous documentation. This documentation must include the prescribed information and analyses. The documentation must be provided to CRA no later than 90 days after the due date of the taxpayer’s income tax return. This documentation is also required to be updated if there are material changes to the information and analyses.
An example of a possible application of the reasonable effort standard is the case where Canco sells $100 million of tangible goods to a U.S.-related subsidiary in 2005. The CRA says that the transfer price should have been $110 million and the company provided documentation within 90 days. A field auditor then reviews the documentation and sends it to the TPRC. The TPRC finds that the documentation provided by Canco was not sufficient to demonstrate that it was made with reasonable effort. The penalty for non-compliance with CRA’s reasonable effort standard for transfer price adjustments is $560,000.
In order to comply with the CRA’s reasonable effort standard, multinational corporations must price goods entering Canada in accordance with fair market value. This will ensure that the CRA’s transfer price is the same as the price if the goods were sold at arm’s length.
When dealing with related parties, it is important to ensure that the terms of trade are arm’s length. In Canada, an arm’s length pricing requires similar conditions for related parties. The arm’s length principle is a general principle that states that the parties should be dealing on the same terms as non-related parties.
Impact of pandemic on transfer pricing
The coronavirus pandemic has wrought significant and varied effects around the world, with implications for all aspects of business and society. In particular, this disease poses significant practical challenges for multinational entities’ transfer pricing arrangements. In this episode, we consider the implications of the pandemic for Canadian businesses.
The Netherlands hasn’t issued specific guidance on government subsidies, but the OECD Guidelines on government policy recognizes that a firm’s arm’s-length price needs to reflect the interventions of the government. Such interventions should be treated as market conditions in the country in which the transfer is made.
The pandemic has delayed some changes in tax laws, including the introduction of COVID-19. In addition, the CRA recently revised its administrative policies related to transfer pricing. But, the pandemic has delayed some important developments, including changes to the recharacterization rules. As a result, the impact of the pandemic on transfer pricing in Canada is unclear.
Moreover, the OECD and the Italian courts have endorsed the use of business strategies in determining transfer prices. In a recent decision, the Supreme Court ruled that the economic interests of the group overrode the arm’s-length principle. This decision illustrates the importance of proper underlying documentation that demonstrates the relevant facts and circumstances and assesses the support of independent parties.
As a result of the pandemic, companies may need to adjust their transfer pricing models to reflect the changes in their global supply chains. This includes re-allocating assets, risks, and functions. Companies should review their existing legal arrangements and consider realistic options. They must also consider the long-term impact of the pandemic on transfer pricing.