Taxpayers and partnerships are required to comply with Canada’s transfer pricing legislation as set out in the Income Tax Act (ITA). Section 247 of the ITA requires taxpayers and partnerships to be able to demonstrate that their transactions with non-resident non-arm’s-length parties are conducted on terms and conditions that would have prevailed if they were dealing at arm’s length. The Canada Revenue Agency (CRA) has the authority to adjust prices or other terms and conditions of transactions to the extent they are not consistent with arm’s-length terms and conditions. Moreover, the CRA has the authority to re-characterise a transaction if it is one that arm’s-length parties would not have entered into, and the transaction was entered into primarily to obtain a tax benefit. Transfer pricing adjustments made by the CRA are subject to an appeal process, which may ultimately culminate in litigation before the courts.
Over the years, courts have determined how the arm’s-length principle is to be applied. In doing so, the courts have construed the power to recharacterise transactions narrowly.
Generally, the CRA follows the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines (OECD Guidelines), as updated from time to time, in administering Section 247 of the ITA. The CRA has issued a variety of documents with guidance including Information Circulars, Interpretation Bulletins, and Transfer Pricing Memorandums (TPMs) that set out its views on a variety of topics related to transfer pricing. While these materials are not law, they provide useful guidance as to how the CRA interprets the law as it pertains to transfer pricing. Of particular importance currently are the TPMs.
As globalisation has accelerated over the last several decades, the volume of global trade has increased apace with a large proportion of this trade happening between related parties. As trade between entities within multinational enterprises grew, a framework to address the potential risk of abuse from an income tax perspective became increasingly important globally and in Canada.
The transfer pricing regime in Canada has evolved over the years and changes have included both legislative and organisational changes to make enforcement more effective. Initially, transfer pricing matters were governed by Subsections 69(2) and 69(3) of the ITA. The provisions addressed whether the amounts paid or received “would have been reasonable in the circumstances if the non-resident person and the taxpayer had been dealing at arm's length”. The original provisions did not set out specific transfer pricing penalties or documentation requirements.
As the USA codified its transfer pricing regime under Section 482 of the U.S. Internal Revenue Code in 1968 and began introducing detailed Treasury Regulations thereunder, including the application of penalties, the consequences of non-compliance in the USA were substantially greater than those in Canada.
Additionally, the OECD conducted its own study on transfer pricing concepts starting in 1970 and published its first transfer pricing guidelines in 1979. The CRA referred to and relied on the OECD's 1979 guidelines on transfer pricing.
Over the years many changes have occurred in Canada and globally including:
Ultimately, Canada introduced Section 247 of the ITA, requiring taxpayers to follow the arm's-length principle and maintain contemporaneous transfer pricing documentation under threat of transfer pricing penalties. The CRA also updated and replaced IC 87-2 with IC 87-2R dated 27 September 1999. IC 87-2R was cancelled as of 30 December 2019, because it is now inconsistent with the interpretation of Canada's transfer pricing rules and the OECD Guidelines.
Canada’s transfer pricing rules apply to transactions with non-arm’s-length non-residents. Section 251 of the ITA deems related parties not to be at arm’s length and addresses whether parties are related. Parties may, however, also be factually non-arm’s length. CRA Folio S1-F5-C1 - Related Persons and Dealing at Arm's Length provides details on the CRA’s interpretation of these rules. Parties are generally related where one, directly or indirectly, controls (de jure control) the other, or both parties are under common control. As paragraph 1.38 of the Folio states: “The following criteria have generally been used by the courts in determining whether parties to a transaction are [factually] not dealing at arm's length:
Section 247 of the ITA does not specifically identify any transfer pricing methods to apply. Rather, the CRA generally follows the OECD Guidelines. Consistent with the OECD Guidelines, the CRA accepts that, when correctly applied, both traditional transactional methods and transactional profit methods result in an arm’s-length price or allocation.
Traditional Transactional Methods
Comparable uncontrolled price (CUP) method
The CUP method, if applicable, provides the highest degree of comparability of the traditional transactional methods, because it both focuses directly on the price of a transaction and requires functional and product comparability.
Resale price method (RPM)
The RPM compares the gross margin earned on sales to arm’s-length parties of a product purchased from a non-arm’s-length enterprise to the gross margin earned either by a member of the group or an arm’s-length person in comparable uncontrolled transactions. The RPM is most appropriate in a situation where the seller adds relatively little value either to the goods or by way of the creation or maintenance of an intangible property such as a marketing intangible.
Cost plus method
The cost plus method determines an arm’s-length price by reference to the gross profit mark-up realised in comparable uncontrolled transactions. The direct and indirect costs of production incurred by a supplier to a non-arm’s-length enterprise are determined and a comparable gross mark-up then is added to those costs.
Transactional Profits Methods
Profit split method (PSM)
The PSM is applied to all members involved in the controlled transaction. The profit split method allocates the total integrated profits related to a controlled transaction between the members. The appropriate split is based on the functions performed, the assets used, and the risks assumed by each party, in relation to what arm’s-length parties would have received. Typically, the PSM is applied in highly integrated operations where there are valuable and unique intangibles that make it impossible to establish the proper level of comparability with uncontrolled transactions to apply a one-sided method. Although there are different methods by which to allocate the profits, the CRA typically recommends the use of a residual PSM.
Transactional net margin method (TNMM)
The TNMM compares the net profit margin of a taxpayer arising from a non-arm’s-length transaction with the net profit margins realised by arm’s-length parties from similar transactions, and examines the net profit margin relative to an appropriate base such as costs, sales, or assets. The appropriate base will depend on the facts and circumstances of each case.
Comparable profits method (CPM)
The OECD Guidelines indicate that the CPM may be acceptable, subject to the extent that its application is consistent with the application and comparability standards set forth for the TNMM in the OECD Guidelines.
Since Section 247 of the ITA does not specify any methods, unspecified methods may be permitted to the extent it can be demonstrated that they produce a reliable, arm’s-length result. This is consistent with the position taken in the OECD Guidelines.
Section 247 of the ITA does not identify any specific methods that should be applied, so by extension does not impose an explicit hierarchy for the application of various methods.
Historically, the CRA was of the view that a natural hierarchy existed in the methods and that certain methods provide more reliable results than others, depending on the degree of comparability between controlled and uncontrolled transactions, even though the OECD moved away from that position in the 2010 OECD Guidelines.
The CRA does not necessarily accept that statistical measures, such as the use of the interquartile range, enhance the reliability of the comparable data. Rather, a careful comparability analysis is required and when reasonable comparables are selected, the full range of results should be indicative of an arm’s-length result. TPM-16 - The Role of Multiple Year Data in Transfer Pricing Analysis presents a more detailed discussion of the CRA’s views on this issue.
Since the CRA generally follows the OECD Guidelines, comparability adjustments are permitted to the extent that they improve the reliability of the transfer pricing analysis. The CRA is generally of the view that all adjustments must be justified and it cannot simply be assumed that adjustments are warranted or that they improve the reliability of the results.
Canada generally follows the guidance set out in the OECD Guidelines and does not have additional specific rules relating to the transfer pricing of intangibles.
Canada generally follows the guidance set out in the OECD Guidelines and does not have additional specific rules regarding hard-to-value intangibles.
Canada does recognise cost contribution arrangements. The CRA generally follows the guidance set out in the OECD Guidelines and does not have additional specific rules.
It is generally difficult for taxpayers to make affirmative transfer pricing adjustments after filing tax returns. The rules related to voluntary disclosures (a process by which a taxpayer can voluntarily report an underpayment of tax and avoid penalties) are generally very restrictive when it comes to transfer pricing issues. Under the current rules, most transfer pricing issues would not be eligible.
If a taxpayer determines that it over reported taxable income, it can file a request with the relevant tax services office (TSO) for a downward adjustment to income. The specific procedures are detailed in TPM-03 – Downward Transfer Pricing Adjustments under Subsection 247(2), which is currently under revision by the CRA. Such adjustments are contemplated in Subsection 247(10) of the ITA, which gives the CRA the discretion to determine whether such an adjustment is appropriate. In practice, it is often very difficult to obtain such adjustments because of the risk of creating double non-taxation.
Canada has an extensive network of agreements, both treaties and tax information exchange agreements under which it may share or gather taxpayer information. It has signed 94 tax treaties and 25 tax information exchange agreements (only 24 are currently in force). Canada is also a signatory to the Multilateral Instrument (MLI).
Canada began a pilot advance pricing agreement (APA) programme in 1990 and formally launched its APA programme in 1993. Since then, Canada has concluded approximately 371 APAs and has 66 more in process (as of its 2019 APA Program report).
The Competent Authority Services Division within the CRA administers the APA programme and sets out the procedures and requirements in Information Circular 94-4R International Transfer Pricing: Advance Pricing Arrangements.
Both APAs and mutual agreement procedure (MAP) cases are handled by the Competent Authority Services Division of the CRA. Since it is the same team handling both types of cases, there is close co-ordination.
Generally, any taxpayer subject to the transfer pricing rules in Section 247 of the ITA is eligible to request an APA. However, there are certain transactions that the CRA will not consider for the APA programme such as one time transactions (this could include certain business restructuring matters), transactions that are hypothetical or planned but not yet occurring, transactions that could be viewed as aggressive and tax avoidance transactions. These issues can be discussed informally or through a pre-filing meeting with the CRA to determine whether the specific circumstances of a given taxpayer are suitable.
The APA programme is a voluntary programme that is intended to be more collaborative than adversarial, and to avoid double taxation rather than sanction aggressive tax planning. Taxpayers that are unwilling to share the information necessary for the tax authorities to address the APA request or taxpayers that are inflexible as to the outcome are likely to be less suited for the programme and may be less likely to pursue an APA to a successful conclusion.
The CRA sets out the procedures and requirements in Information Circular 94-4R International Transfer Pricing: Advance Pricing Arrangements.
Additionally, the CRA has Information Circular 94-4R (Special Release) Advance Pricing Arrangements for Small Businesses, which addresses a modified process for small businesses to seek APAs. Most significantly, small business APAs are unilateral without a rollback (ie, to prior tax years), apply to tangible goods and routine services (not intangibles transactions), do not involve site visits, and enjoy a streamlined submission process so that the company only prepares and submits a detailed functional analysis. The economic analysis is prepared by the CRA.
For a year to be included as an APA year (rather than a rollback year), the pre-filing meeting must take place before the tax return due date for the year in question (this is six months after year-end for corporations).
There is no user fee or cost recovery by the CRA for the APA programme in Canada.
The term of an APA is usually three to five years, but that may vary depending on the facts, circumstances, and resolution of the particular case. Given the time it takes to negotiate APAs, near the end of the process, the CRA generally asks the taxpayer if it would be interested in extending the term of the APA to ensure that the agreement runs for a reasonable amount of time after it is signed. This often results in two to three additional years being added to the term.
The taxpayer may ask, or the relevant TSO may decide, to apply the terms and conditions of an APA retroactively to non-statute-barred taxation years. ITD will discuss the issue of retroactive application with the taxpayer, the responsible TSO and the non-resident entities' tax administrations, if appropriate, as soon as possible during the process.
This usually occurs when the facts and circumstances of the open prior years were similar to those on which the APA was concluded. A request to retroactively apply the terms and conditions of an APA is separate and distinct from an APA request.
Should the CRA make transfer pricing adjustments, Subsection 247(3) of the ITA sets out the penalties that may apply. If the adjustments exceed the lesser of CAD5 million or 10% of revenue, a penalty of 10% of the adjustment, regardless of whether there is a tax deficiency, may apply. A penalty can be avoided if the taxpayer makes reasonable efforts to determine and use arm’s-length transfer prices. If the taxpayer has not prepared contemporaneous documentation, then it is deemed not to have made reasonable efforts and penalties will apply if there is a transfer pricing above the prescribed threshold. Proper contemporaneous documentation is therefore a critical aspect of a taxpayer’s compliance efforts in Canada.
In the event the CRA proposes adjustments that exceed the penalty threshold or proposes to recharacterise a transaction, the auditor is required to refer the matter to the transfer pricing review committee (TPRC) for consideration. The objective is to ensure consistency in the application of penalties and consistency in recharacterisation across the country. The TPRC will review the file, the CRA auditor’s recommendations, and the taxpayer’s written submission and make a determination as to the applicability of penalties or the proposed recharacterisation.
Taxpayers must submit their contemporaneous documentation within three months after the CRA requests it. The CRA is of the view (see TPM-05R) that there is no provision in the ITA allowing the CRA to grant an extension or otherwise exercise discretion when determining whether documentation was timely filed pursuant to the three-month deadline. As a result, if a taxpayer submits the documentation even one day late, that taxpayer would be deemed to have not made reasonable efforts for transfer pricing penalty purposes.
Canada has adopted country-by-country reporting (CbCR), as recommended in the OCED Guidelines, and taxpayers are required to prepare and file the CbCR in the appropriate circumstances. Section 233.8 of the ITA sets out the legal requirements. Additional information is provided in the CRA Guide RC4951 Guidance on Country-By-Country Reporting in Canada, which generally follows the requirements in the OECD Guidelines.
Canada has not formally adopted the other transfer pricing documentation recommendations from BEPS Action 13, specifically the master file/local file format. Canada is of the view that its transfer pricing documentation requirements are already as – if not more – robust than those proposed by the OECD. The documentation requirements in Subsection 247(4) of the ITA specify the required content but do not specify a required format, so while it has not been formally adopted in Canada, the master file/local file format will be acceptable in Canada to the extent that all of the elements required in Subsection 247(4) of the ITA are addressed.
TPM-14 2010 Update of the OECD Transfer Pricing Guidelines affirms the CRA’s commitment to the OECD Guidelines as updated and the applicability of the updated OECD Guidelines to all years available for audit (even if those years ended prior to the issuance of the updated OECD Guidelines). While a new TPM has not been issued to this effect in connection with the 2017 update of the OECD Guidelines, the CRA will generally follow updates to the OECD Guidelines.
Canada follows the arm's-length principle and that principle is mandated in Canada’s transfer pricing legislation in Section 247 of the ITA. When the terms or conditions between the participants in the transaction or series of transactions differ from those that would be made between persons dealing at arm’s length, the CRA can adjust the terms and/or conditions to those that would have been made between parties dealing at arm’s length.
The CRA generally follows the OECD Guidelines, so results from the BEPS project reflected in the OECD Guidelines are generally adopted by Canada to the extent this is consistent with the arm’s-length principle codified in Canadian law. Canada has also signed on to the MLI (with reservations) and the necessary legislation to give effect to its provisions has been enacted.
While Canada has not enacted legislation regarding the OECD Guidelines, the CRA generally follows them and as such, we are beginning to see the impact of changes to the OECD Guidelines on audit controversy.
Canada follows the arm’s-length principle so, to the extent that it can be demonstrated to be consistent with the arm’s-length principle, one entity may bear the risk of another entity’s operations. While the OECD Guidelines may suggest that economic substance, focused on people functions, should be of primary importance, Canada has a long history of jurisprudence that gives significant weight and importance to legal substance (see the discussion of Canadian jurisprudence in 14.2 Significant Court Rulings for more on this point).
Generally, the UN Practical Manual on Transfer Pricing does not have any impact on transfer pricing practice or enforcement in Canada. Canada mainly relies on the ITA, related jurisprudence, TPMs issued by the CRA, and the OECD Guidelines.
Canada does not have any transfer pricing safe harbours.
The CRA issued TPM-17 – The Impact of Government Assistance on Transfer Pricing, which states that the CRA’s policy is that the benefits of any government assistance should remain in Canada unless there is reliable evidence that arm’s-length parties would have treated the government assistance differently given the facts and circumstances.This can be a challenging position for taxpayers to address, particularly if the taxpayer does not have an internal comparable transaction (eg, it outsources the same or substantially similar services to arm’s-length service providers as well as related ones).
Canada has some notable guidance on particular issues. Through a series of Transfer Pricing Memorandums, the CRA has set out its administrative guidance on these issues. Some of the most important of these are listed below.
There is no explicit legislative link between transfer pricing rules and customs rules; however, the values used for each are closely related and the Canada Border Services Agency (which handles customs compliance) often begins its inquiries by examining the importer's transfer pricing policies. Customs audits are handled independently of the transfer pricing audits handled by the CRA because the two are separate administrative agencies. However, given the close connections between transfer pricing and customs matters, an audit in one area could have significant implications for the other.
Transfer pricing audits generally begin with a request from the CRA for copies of the taxpayer’s contemporaneous transfer pricing documentation. As the audit progresses, the CRA may request interviews of relevant personnel, issue queries, provide a proposed transfer pricing adjustment along with its analysis supporting the proposed adjustment. At this stage of the audit, the taxpayer typically makes further representations and, should the proposed adjustment exceed the penalty threshold, prepares a submission to the Transfer Pricing Review Committee responding to the CRA auditor’s referral report and outlining how it made reasonable efforts and therefore should not be subject to transfer pricing penalties.
In the event that a transfer pricing audit leads to a disputed reassessment, there are several options for resolving that dispute. These options include the domestic appeals process (which may culminate in formal litigation), competent authority negotiations under one of Canada’s many bilateral income tax conventions with other countries, and/or seeking a resolution through the advance pricing arrangement procedure. Each of these options has different ramifications and costs and any transfer pricing dispute analysis should consider all three alternatives (assuming that the taxpayer did not waive its rights to object as part of an audit settlement). A taxpayer would typically file a Notice of Objection to preserve its domestic appeal rights in any event. Should it desire to seek competent authority relief instead, the taxpayer may ask that its objection be held in abeyance pending the resolution of the corresponding competent authority request.
Payments and Payment Deferrals
Generally, there are restrictions on the CRA’s ability to pursue collection action while a matter is under objection or appeal. However, for large corporations, those same restrictions do not apply. Large corporations are required to pay half of any disputed federal income tax and related interest/penalties (and the whole of any non-disputed amounts), either half or the full amount of any corresponding provincial tax assessment (depending on the provincial statute), and all withholding tax (arising as a result of secondary adjustments for any deemed dividends). These payment provisions are important to consider when deciding whether to accept a settlement at the audit level. If the taxpayer does not file a Notice of Objection, then it must pay the full amount of the assessment(s) and/or reassessment(s).
Following the issuance of a Notice of Assessment or Notice of Reassessment, the taxpayer may file a Notice of Objection within 90 days with CRA Appeals. For large taxpayers, the Notice of Objection must include all facts and grounds on which the taxpayer wishes to rely and the relief sought. CRA Appeals is charged with providing an independent review of the audit function’s (re)assessment of the taxpayer’s income. CRA Appeals will review the taxpayer’s Notice of Objection, will accord the taxpayer the opportunity to file written submissions and, if the taxpayer wishes to do so, will generally agree to meet with the taxpayer and its advisors. If the federal tax exceeds CAD1 million then there is a mandatory referral to CRA Headquarters. The taxpayer may be able to negotiate a settlement at this stage if it can present well-reasoned positions that are supported by facts.
In some circumstances, a taxpayer may end up reaching a settlement at the audit stage, and as part of that settlement, the taxpayer will be required to waive its right to file a Notice of Objection. In such a case, the taxpayer may still request competent authority assistance pursuant to the MAP procedure in one of Canada’s treaties.
For domestic appeals, given current workloads, it can take 12–24 months for an appeals officer to be assigned. Once an officer is appointed, each case will unfold on its own timeline based on the need to provide additional information or the nature and number of meetings or other consultations with the appeals officer. Cases can be resolved in one to two years, or much longer, if the case is particularly difficult.
Taxpayers also have the option of filing a Notice of Appeal after filing a Notice of Objection and proceeding directly to Tax Court if a decision is not reached in a timely manner (90 days). Alternatively, taxpayers can wait for the conclusion of the administrative appeals process and, if they find the decision unacceptable, can then file a Notice of Appeal and proceed to Tax Court. Litigation would begin in the Tax Court of Canada and would involve many of the usual steps found in a traditional civil action (eg, pleadings, documentary and oral discovery, interlocutory motions, expert witness reports, and a hearing before a Tax Court judge). Decisions from the Tax Court of Canada may be appealed to the Federal Court of Appeal. The final step available is an appeal to the Supreme Court of Canada, which can only happen if leave is granted by the Court based on the national importance of the issue. Litigation through the courts can typically take from two to four years, or in some cases longer.
Mutual Agreement Procedure
Most often, the preferred route to resolving the double taxation issues that arise from adjustments to transfer prices is seeking competent authority assistance through the mutual agreement procedure provisions of the relevant bilateral tax treaty. Canada has an extensive network of tax treaties that contain provisions related to relieving double tax through mutual agreement processes.
Procedurally, taxpayers commonly file Notices of Objection and hold them in abeyance while pursuing competent authority assistance. Taxpayers cannot pursue both simultaneously. If the appeal covers multiple issues, some subject to a MAP request and others that are not, the issues can typically be bifurcated and the issues not subject to the MAP can proceed at appeals while the other issues are held in abeyance while the MAP process unfolds. However, if a taxpayer reached a settlement with the CRA at the audit level and waived its rights to file a Notice of Objection, the taxpayer may be limited to seeking competent authority assistance.
Deadlines for pursing competent authority assistance vary by treaty. Under the treaty with the USA, notification must be provided within six years of the taxable year-end in question with no specific deadline for filing the actual competent authority request. Most of Canada’s other treaties have limitation periods that typically prohibit reassessing action after five or six years from the taxable year-end and require the filing of the request within two or three years of such action.
Cases typically take approximately 24 months to resolve through the MAP process.
For taxpayers to accept a MAP resolution they must sign a waiver of their right to object so the MAP decision will be final. If taxpayers disagree with the MAP resolution, they may reject the decision and pursue the domestic appeals route by reactivating the objection being held in abeyance, assuming that the taxpayer filed an objection.
An increasing number of treaties contain arbitration provisions so if a MAP resolution is not reached within the specified time frame, treaty cases could be submitted to arbitration. Practically speaking, arbitration has been beneficial under the Canada-US treaty and is expected to continue to be so as more treaties are amended to include arbitration (including as a result of the MLI, to which Canada is a signatory).
Most taxpayers rely on the mutual agreement procedures set out in Canada’s extensive network of tax treaties to resolve transfer pricing issues and avoid double taxation. It is usually where a MAP is not available or not effective that taxpayers resort to litigation. As a result, relatively few transfer pricing cases are litigated in Canada. Also, given that Section 247 of the ITA only became effective for taxation years beginning after 1997, judicial precedents are relatively novel and have been somewhat limited in number over the last 12 years or so.
The following cases decided in the last several years are worth considering.
Her Majesty the Queen v GE Capital Canada Inc. (GECC): Intercompany Guarantee Fees
The FCA allowed GECC to deduct the full amount of the guarantee fee it paid to its US parent company. At issue were guarantee fees charged by GE Capital Corporation Inc. (GECUS) to its Canadian subsidiary, GECC, for the explicit guarantee provided by GECUS on all of GECC’s borrowings from 1996 through 2000. The Canadian Minister of National Revenue had disallowed the deduction of the entire amount of the fees, on the basis that the fees should be zero due to the implicit guarantee inherent in the parent-subsidiary relationship. This issue is of potential importance not only for corporations investing in Canada but also those investing in other OECD countries because of the court’s references to the OECD Guidelines.
Tax Court of Canada (TCC) decision
The TCC ultimately found in favour of GECC and vacated the assessments. As part of its decision, however, the Court found that GECC’s approach to determining the fees by assessing GECC’s credit rating as if it was independent of GECUS did not appropriately consider all economically relevant circumstances. The TCC stated that GECUS’ ownership must be considered when determining the credit worthiness of GECC, because, inter alia, it impacted the risk profile of the transaction in a manner that made it differ from that between truly independent entities.
Federal Court of Appeal (FCA) decision
The FCA ruled that the implicit support (ie, GECUS’s ownership of GECC) was correctly and necessarily considered. The FCA noted that “[t]he suggestion that implicit support should be ignored would require the Court to turn a blind eye on a relevant fact and deprive the transfer pricing provisions of their intended effect.” The Court underscored the presence of comparables where such implicit support existed. In the GECC case, the focus was on the “comparable circumstances” clause in the OECD Guidelines at paragraph 1.6. The implication is that the parent-subsidiary relationship becomes an economically relevant circumstance to the analysis and impacts the determination of the arm’s-length price for a transaction. Instead of considering a transaction between a parent and subsidiary and asking what the terms and conditions would have been if the entities were unrelated, the Courts considered the question, what would the terms and conditions be if an arm’s-length party entered into the transaction with that subsidiary of a multinational corporate group. The answer was that the parent-subsidiary relationship would cause arm’s-length lenders to assume a more favourable credit worthiness than if GECC had been an independent, standalone entity.
GlaxoSmithKline Inc. v Her Majesty the Queen (GSK Canada): Pricing for Active Pharmaceutical Ingredient and Connection with other Intercompany Transactions
This case involved the arm’s-length nature of the amount GSK Canada paid to a related Swiss company, Adescha S.A., for the purchase of the active ingredient used in the Zantac products sold by GSK Canada, which was also included in a licence transaction with another related party in the United Kingdom. The TCC accepted the CUP advanced by the Crown based on the lower prices of the generic version of the active ingredient that were available in Canada.
In evaluating whether the generic market transaction was comparable, the TCC declined to consider the licence agreement under which GSK Canada paid a 6% royalty. The result of the TCC approach was the realisation by GSK Canada of profits significantly in excess of those that would be realised by a similarly situated party dealing at arm’s length.
GlaxoSmithKline appealed to the FCA, which agreed that all relevant circumstances must be considered, including the intercompany licence agreement, and returned the case to the TCC for rehearing and reconsideration. Leave to appeal the case to the Supreme Court of Canada was granted and the Supreme Court agreed that the licence agreement was a relevant circumstance and must be considered. The case was returned to the TCC to reconsider while factoring in the impact of the licence agreement. The parties settled the case on undisclosed grounds following the Supreme Court of Canada decision. The consistency in the courts’ approach between this case and GECC supports taking a holistic approach when considering transfer prices for any given transaction and ensuring that all economically relevant circumstances are considered appropriately.
Alberta Printed Circuits Ltd. v Her Majesty the Queen: Setup Services for Production of Prototype Circuit Boards
This case addressed the appropriate transfer prices to be paid by Alberta Printed Circuits Ltd. (APC) to APCI, Inc. (APCI), a Barbados international business company, for set-up services (setting up the production of prototype circuit boards). APC relied on the CUP method arguing that the prices that APC charged to third-party customers for the services provided by APCI served as a CUP for the prices that APCI should charge to APC, and it was largely successful in its appeal to the Tax Court.
The TCC strongly preferred APC’s CUP method over the CRA’s TNMM analysis, and criticised the CRA for not doing more to identify and evaluate potential CUPs. While APC relied primarily on internal CUPs, APC’s external CUPs were rejected by the CRA, citing a lack of evidence available to evaluate comparability, because the data was from competitor websites or interviews with competitors. The TCC also found the TNMM less reliable for a variety of reasons, including the potential presence of intangible property in the form of valuable software copyrights owned by APCI, the tested party under the CRA’s approach.
The TCC addressed the fact that APC earned no profit directly from the resale of the services provided by APCI, noting that, “In addition, the Bambers [the family that owned APC] were, in effect, now in an arrangement where they kept 100 percent of the profits from manufacturing [realised by APC] and still got two-thirds of the profits from APCI [from performing set-up services], as per their deal.” The deal referenced was a tax structure that the Bambers and Mr McMuldroch (the President of APCI) entered into whereby APCI was owned by a holding company, the shares of which were held for the benefit of their respective families. It does not seem consistent with the OECD Guidelines that reference should be made to the gains realised through the payment of dividends when evaluating the arm’s-length nature of transfer prices and the lack of profit realised by one party to the transaction.
Finally, the TCC determined it was necessary to unbundle the various transactions at issue because CUPs were available to evaluate the prices for set-up services. APC argued that the other amounts were immaterial and that its analysis showed that after paying these fees, it still realised profits comparable to other circuit board manufacturers. The TCC did not find this indirect evidence compelling. Due to the lack of direct evidence submitted regarding the pricing for the other services transactions, the TCC disallowed those other amounts.
Cameco Corporation v The Queen
This case addressed several issues including the role and importance of contracts in transfer pricing, substance issues, and ultimately intercompany pricing. The CRA advanced three alternative arguments: (i) the arrangement was a sham and should be disregarded, (ii) the transaction should be recharacterised, or (iii) the transfer pricing should be adjusted. The TCC found in favour of the taxpayer on all three arguments.
In brief, Cameco, headquartered in Canada, is one of the world’s largest publicly traded uranium companies. It set up subsidiaries in Luxembourg (CESA” and Switzerland (CEL) that were granted a long-term supply contract for uranium that they could then resell outside of Canada. At the time the arrangements were put into place, the price of uranium on the global markets had been very stable for decades and these entities were not expected to earn significant profits.
These entities also entered into purchase agreements with unrelated parties. This included purchasing uranium from decommissioned Russian nuclear weapons. These purchases were often undertaken to prevent the market from being flooded with uranium and depressing prices. These contracts were also not expected to generate significant profits at the time.
"A transaction is a sham when the parties to the transaction present the legal rights and obligations of the parties to the transaction in a manner that does not reflect the legal rights and obligations, if any, that the parties intend to create".
The arrangements created by the contracts in this case were not a façade but an accurate reflection of the legal reality intended by all parties involved. Through these contracts CESA legally took on the rights, obligations, and risks of the transactions, which is precisely what the parties intended and understood. In the absence of an intent to deceive, the fact that these agreements were in the best interests of the Cameco group as a whole and may have been tax-motivated does not transform the legal arrangements into a sham.
"The assumption underlying paragraph 247(2)(a) of the ITA is that parties at arm’s length "would enter into the transaction or series... but on different terms or conditions". The goal of 247(2)(c) is to determine what unrelated parties would have paid in the same circumstances. It permits an adjustment in the quantum but not the nature of the amount.
The assumption underlying paragraph 247(2)(b) is that parties at arm’s length "would not enter into the transaction or series on any terms or conditions but that in the circumstances there is an alternative transaction or series that arm’s length parties would enter into on other terms and conditions." "[T]he adjustment may alter the quantum or the nature of the amount."
The key question from a transfer pricing perspective is: can all of the transactions undertaken by the Cameco group since the 1999 restructuring (the initiation of the structure and transaction in question) be treated as a single “series” and subject to transfer pricing review?
The TCC found that the answer is no. The heart of the transfer pricing rules is a comparability analysis that cannot disregard the transactions that did in fact take place or the broader circumstances. To tax Cameco as if nothing in fact occurred because arm’s-length parties would not have entered into such arrangements “…completely disregards the purpose and focus of the transfer pricing rules by circumventing the comparability analysis that is at the heart of the rules.”
Subparagraph 247(2)(b)(i) asks: “Would the transaction or series have been entered into by arm’s length persons acting in a commercially rational manner?”
"There is nothing exceptional, unusual or inappropriate about [Cameco’s] decision to incorporate CESA and have CESA execute [any of these transactions]". The parent of a corporate group is free to establish subsidiaries and to decide which among its subsidiaries will earn income. “I [Justice Owen] would go so far as to suggest that such behaviour is a core function of the parent of a multinational enterprise.” The principal purpose of the series stemming from the restructuring was to save tax, but that does not lead to condemnation of Cameco’s behaviour. “In taking advantage of the foreign affiliate regime, the Appellant [Cameco] was simply utilizing a tax planning tool provided by Parliament.”
The subsequent transactions were designed for the bona fide purpose of maximising profits by "placing the profit from an active business carried on outside Canada in a jurisdiction that imposed lower taxes than Canada."
The analysis under the traditional transfer pricing rules must consider the circumstances in which the transaction was entered into – not the outcomes of the transaction from a hindsight perspective. “A person’s subjective view of a market is not an objective benchmark and reliance on such views introduces intolerable uncertainty into the transfer pricing rules."
Cameco’s placement of the agreements in CESA did not reflect terms other than what would have been in place between persons dealing at arm’s length. At the time the agreement was entered into, it had “no intrinsic economic value”, as evidenced by the nature of the negotiations between Cameco and the various third parties. The fact that Cameco negotiated or administered the contracts on behalf of CESA does not in itself attract a transfer pricing adjustment. The transaction was designed to control the supply of uranium, which benefited everyone in the market at the time. It turned out to be profitable only because of an unforeseen rise in the price of uranium. Justice Owen made reference to the OECD Model Convention and highlighted the difference between a “recharacterization rule” and paragraph 247(2)(d): Strictly speaking, paragraph 247(2)(d) does not authorize the Minister to recharacterize the transaction or series....
"Rather, paragraph 247(2)(d) authorizes the Minister to identify an alternative transaction or series that in the same circumstances would be entered into by arm’s length parties in place of the transaction or series and then to make an adjustment that reflects arm’s length terms and conditions for that alternative transaction or series."
While the OECD Convention is helpful, the final determination of the application and scope of Canada’s transfer pricing rules must be based on the wording chosen by Parliament.
Federal Court of Appeal
The Crown appealed the decision to the Federal Court of Appeal. In the appeal, the Crown dropped the sham argument and focused on the recharacterisation and transfer pricing adjustment arguments. The appeal was dismissed.
The decision added clarity to the scope and application of paragraphs 247(2)(b) and (d). The Crown argued that Cameco Canada would not have entered into the transaction or series of transactions with an arm’s-length party and as such the income should be reported by Cameco Canada. The Court made clear that this is not the correct interpretation of the provision.
The decision makes clear that the so called recharacterisation provision in 274(2)(b) and (d) does not allow the CRA to disregard a transaction or effectively ignore the separate existence of CEL. Rather, if the transaction or series it is one that no arm’s-length parties would enter into under any terms and conditions another transaction or series must be substituted.
Leave to appeal to the Supreme Court of Canada was denied.
In its 2021 Federal Budget, the Canadian government announced its intention to release a consultation paper on "possible measures to improve Canada's transfer pricing rules" and "[protect] the integrity of the tax system" in response to concerns "highlighted" by the FCA's decision in Cameco.
It is apparent from reviewing these decisions that the Canadian courts give weight to legal substance, meaning that contracts matter, which is consistent with Canadian tax law generally. However, this legal adherence was sanctioned by the courts as long as there was market evidence to support the transactions in question. Contrast that with the current views in the OECD Guidelines that give much greater weight to people functions and the notion of economic substance. Taxpayers should be mindful of the relative weight afforded to these factors depending on the path to resolution for transfer pricing disputes that they select (eg, MAP or litigation).
Canada does not impose restrictions on outbound payments relating to uncontrolled transactions.
Canada does not impose restrictions on outbound payments relating to controlled transactions.
Subsection 161(6) of the ITA provides that the payment of tax may be postponed without interest where the funds in respect of which the tax arises cannot be transferred to Canada due to foreign exchange controls and requiring payment of the tax may result in “extreme hardship”.
The CRA publishes an annual report on the APA programme that highlights a variety of programme statistics. No taxpayer specific information is disclosed in the report. Rather, data includes information on case inventory, average completion times, the frequency of use of different transfer pricing methods, the industries involved, and other generalised information. The reports are also used as a means to share guidance on developments within the programme.
The CRA does not issue specific reports related to transfer pricing audits. However, the CRA does issue annual reports on the MAP programme. Like the APA programme reports, no taxpayer specific data is disclosed. Rather, data includes information on case inventory, average completion times, the frequency of use of different transfer pricing methods, the industries involved, and other generalised information. The reports also provide information on the reasons for MAP cases not resulting in the relief of double taxation.
TPM-04 Third-Party Information sets out the CRA’s views on the use of so called “secret comparables” or more accurately, third party information that may be non-public and therefore unavailable to the taxpayer at the time it prepared its transfer pricing documentation and set its transfer prices.
The CRA notes in TPM-04 that it will continue to use confidential third-party information as an audit tool for screening purposes and for secondary support (that is, so-called "sanity checks"). However, it intends to only use the information as a last resort to form the basis of any assessment and will make every effort to develop an assessing position based on publicly available information to facilitate negotiations with the taxpayer as well as reduce the likelihood of double taxation.
At this time (April 2021), there is little official guidance from the CRA on the impact of COVID-19 on transfer pricing. The CRA has announced that it expects that the guidance in TPM-17 will apply to any government support provided in response to COVID-19 (ie, that the benefits of all such support will remain in Canada). Applying the guidance in TPM-17 in connection to COVID-19-related government support can lead to outcomes that are not intuitive, suggesting that both taxpayers and tax authorities will have challenging issues to consider as these issues come up for audit in future years.
The CRA also generally follows the OECD Guidelines and we anticipate that the CRA would similarly follow the guidance recently issued by the OECD in its document Guidance on the transfer pricing implications of the COVID-19 pandemic. See Baker’s article OECD guidance on transfer pricing implications of COVID-19 for further details.
The government of Canada passed legislation that temporarily extended a variety of deadlines across a range of areas from filing tax returns through to the litigation process. As of the writing of this article (April 2021), such extensions and waivers have generally lapsed so they will not be discussed in any detail.
In the early stages of the pandemic many CRA resources were focused solely on delivering the supports provided for by the government of Canada to individual taxpayers so audit activity was largely suspended for most issues and taxpayers. However, as of the writing of this article, the CRA has adapted to the work-from-home rules facing many parts of the country and most of its activities have resumed. Cases may proceed a little more slowly than normal given the limitations faced by both the CRA and taxpayers facing restrictions but they are proceeding.
A Shift in the International Tax Landscape
There has been a shift in the international tax landscape in recent years, driven in part by increased media attention and a demand by the public that companies pay their “fair share”, that is likely to be further fuelled by the COVID-19 pandemic and its economic impact.
Despite ongoing work by the Organisation for Economic Co-operation and Development (OECD) to address base erosion and profit shifting (BEPS), some countries have started to take unilateral action in response to increasing political pressure at home. The situation has been further complicated as a result of certain measures failing to gain the support of Canada’s closest neighbour, the USA, which opted out of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI), and has been sitting on the side-lines of Pillar One (targeting the digital economy). As a result, multinationals are often required to comply with multiple (and sometimes conflicting) regimes.
While Canada is a party to the MLI (although reserving on a number of measures) and continues to be actively involved in the OECD’s work on Pillars One and Two, the Canada Revenue Agency (CRA) is of the view that Canada’s existing domestic rules provide it with a number of tools to combat perceived BEPS, including the transfer pricing “recharacterisation” rule found in paragraphs 247(2)(b) and (d) of the Canadian Income Tax Act (ITA). In recent cases (discussed below), the CRA has demonstrated an increased willingness to rely on such rules. The Canadian government has further indicated that a “made in Canada” approach is not out of the question, should the response of the international tax community not be sufficient (or sufficiently quick) to address Canada’s concerns.
Against this background, it will serve multinationals to take a more proactive approach to transfer pricing, setting the stage to defend against the (increasingly likely) possibility of controversy. In fiscal years 2020/2021, the potential impact of the COVID-19 pandemic on the assumptions underlying a group’s transfer pricing policies will also need to be considered when preparing tax returns and contemporaneous documentation.
Recent Canadian Cases under the Recharacterisation Rule
The recharacterisation rule allows for transactions between non-arm’s-length parties to be recharacterised if the transaction or series of transactions would not have been entered into between persons dealing at arm’s length. Despite the potentially sweeping consequences of this rule, the CRA unsuccessfully advanced arguments under the recharacterisation rule in two recent appeals – Canada v Cameco Corporation (2020 FCA 112) (Cameco) and Agracity Ltd. v Canada (2020 TCC 91) (Agracity).
In Cameco, a Canadian parent company was part of a consortium that negotiated uranium purchase agreements with arm’s-length suppliers. The Canadian parent company formed a foreign subsidiary to handle international sales of uranium, and designated it as the signatory under the purchase agreements. The purchase agreements and business were later transferred to another foreign subsidiary. The Canadian parent company provided support to the foreign subsidiaries, including a guarantee and administrative services. The price of uranium unexpectedly rose, and the foreign subsidiaries realised significant trading profits. The CRA argued that the Canadian parent company would not have entered into the transactions it entered into with the foreign subsidiaries with arm’s-length parties, so that paragraphs 247(2)(b) and (d) of the ITA permitted the Canadian parent company to effectively be treated as the purchaser. In concluding that the recharacterisation rule did not apply, the Federal Court of Appeal (FCA) held that the recharacterisation rule does not ask whether the particular taxpayer would have entered into the transactions with arm’s-length parties. Instead, the test is objective: asking would (hypothetical) arm’s-lengths parties have entered into the transactions, under any terms or conditions? In reaching this decision, the FCA underscored the importance of legal substance, finding that the CRA’s position inappropriately ignored the separate existence of the foreign subsidiaries. The CRA sought, but was denied, leave to appeal the FCA’s decision to the Supreme Court of Canada (SCC).
In Agracity, due to Canadian trade regulations, a foreign affiliate of a Canadian company sold a generic herbicide product to Canadian customers. The Canadian company provided certain logistical services to the foreign affiliate. The CRA was of the view that the foreign affiliate was “an empty shell” and that the Canadian company performed all the functions, and so should recognise all the profits, either under the doctrine of “sham” or Canada’s transfer pricing rules. The CRA argued both that arm’s-length parties would not have entered into the transactions (ie, so that the recharacterisation rule applied) and that the terms and conditions of the transactions were not arm’s-length terms and conditions. The Tax Court of Canada was unconvinced, finding that there was no deception, and no “material support” for applying either the recharacterisation or pricing rule.
What to Expect Next
Despite recent setbacks in the courtroom, it seems likely the CRA will continue to advance transfer pricing adjustments under the recharacterisation rule. The CRA recently cancelled Information Circular IC87-2R “International Transfer Pricing” on the basis that it did not align with the CRA’s current views, including because it suggested that recharacterisation was a “last resort”. The CRA has commented that it is now of the view that this rule is of broader application.
In this vein, the CRA has been reviewing certain hybrid financing structures under the recharacterisation rule; taking the unusual step of releasing a “Notice to tax professionals” announcing that it had resolved a file involving a “hybrid mismatch arrangement” on the basis that paragraphs 247(2)(b) and (d) of the ITA applied. This arrangement involved a US corporation (USco) that lent to a Canadian subsidiary (Canco) it held through a US LLC (LLC). The LLC funded Canco’s interest payments pursuant to a forward subscription agreement, and USco made matching capital contributions to the LLC. The CRA took the position that arm’s-length parties would not have entered into this arrangement, and that the closest arm’s-length analogue would be a 100% equity transaction.
Taxpayers should be aware that the CRA will not negotiate the application of the recharacterisation rule in the context of a mutual agreement proceeding (MAP), on the basis that the rule is a domestic anti-avoidance rule, and so does not result in taxation not in accordance with Canada’s tax treaties (the CRA takes a similar position with respect to Canada’s general anti-avoidance rule). This position was recently confirmed by the CRA in its revised draft Information Circular IC71-17, "Competent Authority Assistance under Canada's Tax Conventions". The CRA will, however, submit the case to its treaty partner under a MAP, so that the other competent authority may provide relief.
Recent legislative developments may serve to embolden the CRA in its application of the transfer pricing rules. In its 2019 Federal Budget, the Canadian government proposed an amendment to Canada’s transfer pricing rules to set out the “order” in which the rules apply: first, initial amounts are to be determined under the ITA; second, these initial amounts are adjusted under the transfer pricing rules; and third, the ITA is applied to the adjusted amounts. The CRA is of the view that this rule “clarifies” that the transfer pricing rules “trump” the more specific rules in the ITA applicable to non-arm’s-length transactions (although admits it may have considered this rule to be a change 15 years ago). As a result, taxpayers will not be protected from transfer pricing adjustments by virtue of complying with rules that may once have been thought of as “safe harbours” (such as Section 17 of the ITA, which may deem interest income where a Canadian resident taxpayer charges less than a prescribed rate of interest to a non-resident group member).
Further legislative changes appear to be forthcoming. In comments during a recent event for tax professionals, the CRA indicated that – one way or another – it did not think the decision in Cameco could be left to stand. The CRA suggested that the COVID-19 pandemic – and the government’s remedial response to it – could have the effect of “resetting” the social contract, sanctioning the imposition of a heavier tax burden on companies. In that respect, in its 2021 Federal Budget, the Canadian government announced its intention to release a consultation paper on "possible measures to improve Canada's transfer pricing rules" and "[protect] the integrity of the tax system" in response to concerns "highlighted" by the FCA's decision in Cameco. This follows announcements made by the Canadian government in its 2020 Fall Economic Statement (the Statement) that it would be committing over CAD600 million of additional funding over five years to target “international tax evasion and aggressive tax avoidance”.
Preparing for Controversy
Complying with rapidly changing (and increasingly divergent) global requirements means that companies must continually evaluate their transfer pricing policies and how they are being applied – routine updates to transfer pricing documentation are no longer sufficient. This should not be viewed as (merely) a compliance burden, but an opportunity to develop and support a narrative in preparation to defend against a potential controversy. It should be expected that controversies will become more frequent as conflicts emerge between rules applicable in different jurisdictions, and tax authorities take more aggressive actions to protect their tax base and raise revenue.
While companies may be hesitant to increase their legal spending (particularly in light of the heavy economic impact of the COVID-19 pandemic), taking these steps now can pay off in the future. For example, the Cameco litigation took more than ten years to resolve and, according to statements made by the taxpayer in the course of an application for costs, the taxpayer incurred more than CAD57 million in legal fees and disbursements (these statements were made before the completion of the Federal Court of Appeal hearing and application for leave to the SCC).
More taxpayers are also taking advantage of Canada’s advance pricing arrangement (APA) programme (particularly to obtain bilateral APAs) to provide certainty and avoid double taxation. The CRA has recently indicated that it may be willing to consider negotiating APAs on business restructurings and financing arrangements (two topics it has historically been hesitant to consider), potentially expanding the availability of the programme.
In developing a global approach, taxpayers should be aware that a downward transfer pricing adjustment is not guaranteed in Canada (eg, one cannot be assured that the CRA will give credit for an underpayment on one transaction when proposing an adjustment for an overpayment on another transaction). Such adjustments are at the discretion of the CRA pursuant to Subsection 247(10) of the ITA. The CRA has indicated that in choosing whether to exercise its discretion to allow a downward adjustment, it is motivated by a desire to avoid double non-taxation. The CRA is currently working on updating Transfer Pricing Memorandum TPM-03, "Downward Transfer Pricing Adjustments under Subsection 247(2)”. The Tax Court of Canada (TCC) recently confirmed in Dow Chemical Canada ULC v Canada (2020 TCC 139) (Dow Chemical) that it (and not the Federal Court) has jurisdiction in respect of the CRA’s exercise of discretion under Subsection 247(10). This decision is under appeal to the FCA.
The Impact of the COVID-19 Pandemic
Recent events will, of course, require special consideration when preparing tax filings and contemporaneous documentation for fiscal years 2020/2021. The CRA has indicated that while it does not anticipate “across-the-board” changes to its transfer pricing policy or to its treatment of APAs, the impact of the pandemic will be considered on a case-by-case basis. For instance, current circumstances might impact the CRA’s selection of transfer pricing methodologies or be considered by the CRA to undermine the assumptions that were made when an APA was negotiated.
The CRA has also confirmed that its (already controversial) policy regarding the impact of government assistance set out in Transfer Pricing Memorandum TPM-17, "The Impact of Government Assistance on Transfer Pricing" will apply to COVID-19 relief. According to this policy, where a cost-based transfer pricing methodology is used, the CRA is of the view that the cost base of goods, services or intangibles sold by a Canadian taxpayer should generally not be reduced by the amount of government assistance received by the Canadian taxpayer, unless there is reliable evidence that this is what arm’s-length parties would have done. The consequences of the application of this policy may be substantial. Consider, for example, a Canadian subsidiary that earns fees for its services to a non-resident group member of cost plus 10%. Typically, if the Canadian subsidiary incurred costs of CAD100, it would have fees of CAD110, and profit of CAD10. If the Canadian subsidiary received a CAD10 COVID-19 subsidy (such as the Canada Emergency Wage Subsidy, or Canada Emergency Rent Subsidy), then under the CRA’s policy, the Canadian subsidiary’s costs should remain CAD100 and its fee CAD110, now resulting in CAD20 of profit (ie, the CAD10 mark-up plus the CAD10 subsidy).
Taxpayers should expect that the momentum in international tax and transfer pricing development will continue to build in response to the COVID-19 pandemic. Taking steps now to establish globally coherent and well-supported transfer pricing policies will set multinationals up for the future.