Revenue Canada releases details of advance pricing arrangements program.

• Author: Boidman, Nathan

I. Overview

On December 10, 1994, the Canadian government announced that it was formally adopting an Advance Pricing Arrangement (APA) program, styled along that adopted a few years earlier by the United States.[1] APAs are agreements between taxpayers and Revenue Canada (or both Revenue Canada and the governments of other treaty countries) about the method by which prices for intercompany transactions will be established. Normally the agreement does not establish a specific price or prices but rather the pricing methodology (transfer price methodology -- TPM).

That development was ironic because Revenue Canada[2] had steadfastly refused to consider such a procedure in the late 1980s on the grounds that such an approach would somehow hamper the competent authority procedure in respect of issues arising after the fact. Now, nearly 15 years after initially rejecting the notion and some 7 years after deciding to adopt it, Revenue Canada in March 2001 released "Comprehensive Guidance on Advance Pricing Arrangements (APAs)."[3]

II. Reasons for Seeking an APA

1. Reason #1: Transfer Price Related Penalties

   1. Scope of Penalties. An interest in the APA program often will turn on whether the Canadian party to an intercompany transaction can be potentially subject to specific penalties arising out of the use of transfer prices that are ultimately found by a court to be so inaccurate that they have understated Canadian income by an amount that reaches the threshold of penalties. The interest increases where the other country involved, for example, the United States, also imposes such penalties. Under both Canadian and U.S. law, transfer price related penalties can apply where the income has been understated by an amount exceeding the lesser of $5 million or 10 percent of the gross sales (of goods or services) of the relevant Canadian or U.S. party.[4]

   Where the threshold for Canadian penalties is crossed, the penalty under subsection 247(3) is a tax of 10 percent of the understated income. In the United States, there is a dual-level penalty system. The first (entailing a penalty equal to 20 percent of the additional tax payable by reason of understated outbound or overstated inbound transfer prices) involves the threshold of either (1) the lesser of $5 million of understated income or 10 percent of gross sales or (2) a situation where the U.S. taxpayer used prices that are 200 percent or more or 50 percent or less than arm's-length prices. The second (entailing a penalty of 40 percent of understated tax) involves an understatement exceeding either (1) the lesser of $20 million of understated income or 20 percent of gross receipts or (2) a situation where the taxpayer used prices that are 400 percent or more or 25 percent or less than arm's-length prices.

   Given the U.S. approach, the effective tax associated with a penalty assertion at a U.S. federal corporate tax rate of 35 percent is, in the first case, some 7 percent (20 percent x 35 percent) and in the second case, 14 percent (40 percent x 35 percent). Therefore, the Canadian "tax" of 10 percent is more or less half way between the two extremes of the U.S. effective tax cost for inaccurate transfer prices. Moreover, in this respect, the U.S. approach is such that if there are losses in the year, the penalty rule for understated income from transfer price arrangements may not result in an actual, immediate tax liability, whereas the Canadian penalties impose an immediate tax without regard to whether the assessment of income related to transfer pricing results in net taxable income for the year.

   2. Basic Response to Scope of Penalties. The spectre of penalties may be dealt with in one of two ways. First, there are safe harbors potentially available by complying with the associated rules respecting the preparation of contemporaneous documentation, with the objective of showing that inaccurate prices arose from "reasonable efforts." Second, there is the preemptive approach of advance pricing arrangements (APAs).

   The penalty rules, which apply to tax years commencing after 1998, require in order that there be a penalty that (1) the taxpayer's transfer prices are inaccurate and (2) the taxpayer did not make "reasonable efforts" in arriving at those "wrong" transfer prices.[5] The taxpayer will be deemed not to have made such reasonable effort if the taxpayer has not prepared, by the time it has to file its tax return for the tax year in question (which is six months after the tax yearend), "contemporaneous documentation" as set out in subsection 247(4) of the Income Tax Act. Preparing such documentation, however, does not automatically mean the taxpayer will be considered to have made "reasonable efforts."

   Most taxpayers (where business dealings rise to the level of the penalty thresholds) will consider that there is a serious threat that Revenue Canada could convince a court that the prices are not "right" (and thus be exposed to penalties) and will enter into the "documentation" process.

   3. The Risk of Penalties and the Inherent Nature of Transfer Pricing. The risk of exposure to penalties stems from the inherent nature of tax law in countries (such as Canada or the United States) that adopt as a legal principle the "arm's-length principle" as a means of governing the tax effects of intercompany transactions (as opposed to mechanical formulary income allocation where there has been intercompany transactions). The inherent nature is the uncertainty and subjectivity of a legal principle that is bound up in facts and circumstances. The issue is exacerbated when tax administrators (including Revenue Canada) act as though (1) there is a cohesive set of "rules" governing intercompany transactions, (2) a taxpayer has the capacity to voluntarily comply with these rules, and (3) the taxpayer can choose either to comply or, instead, deliberately manipulate these "rules" to distort appropriate income reporting.[6]

   An associated theme in considering an APA in the Canada-U.S. context is that, aside from differences in procedural factors, transfer pricing, per se, is essentially identical in both countries (and most other countries as well), being unified by the use of "arm's-length prices." The thesis here, however, that regardless of what is written in regulations under section 482 of the Internal Revenue Code or Revenue Canada's views of the manner of applying subsection 247(2) of the Act,[7] a judge in either Canada or the United States could well come to the exact same conclusion about any particular transfer price issue.[8]

   Subsection 247(2) of the Act sets out the requirement that intercompany pricing conform with the arm's-length principle. The statute contains no transfer-pricing "methods" to apply the arm's-length principle and does not provide the Department of Finance with the authority to write regulations for such purpose. Revenue Canada seeks to apply the arm's-length principle in accordance with the transfer-pricing "methods" developed and published by the Organisation for Economic Co-operation and Development.[9] A Canadian court is not, however, in any way bound by anything written by Revenue Canada views or the OECD.

   Canada has only had one "real" transfer-pricing issue[10] dealt with by a court. In Hofert,[11] the Tax Review Board decided, well before the establishment of formal transfer-pricing methodologies, that the transfer-pricing issue was essentially a question of "facts and circumstances" and the obvious place to start the inquiry is "comparables." Thus, in the case, the court rejected Revenue Canada's position that a Canadian subsidiary (of a U.S. parent), which harvested Christmas trees in British Columbia and sold those trees at $3 a tree in small quantities to independent local retailers but sold the same trees at $2 a tree in massive quantities to its U.S. parent (which acted as a distributor to retailers), should have used, for its transfer price, the same $3 it charged to the local Canadian retailers. The Tax Review Board found that there was simply no comparability between the circumstances of the unrelated party sales and the related party sales (other than there being the same product).[12]

   Revenue Canada generally proceeds as though it could be proven to a court that there is a predictable, objective way of determining transfer pricing between members of a multinational group and in particular by application of the OECD methods. There appears, however, to be no reason why a court today would take any different approach than what was taken in 1962, namely, a transfer-pricing issue comes down to the particular facts and circumstances.

2. Reason #2: The Risk of Revenue Canada-IRS Disagreement

   An associated factor in considering an APA in the Canada-U.S. context is the potential for disagreement between the two countries. The IRS favors (when good comparables are not available) jumping to bottom-line profit comparisons, that is to say, the comparable profit method (CPM). In contrast, Revenue Canada insists that, in concept at least, one should try wherever possible to first use traditional "transactional" methods, that is to say, where there are not comparables, the secondary transactional methods, resale price and cost plus. If it is necessary to go to other methods that relate to profit, Revenue Canada advocates the "transactional net margin method" (TNMM) approach over CPM, though Revenue Canada stated in its 1999 information circular that it will accept CPM in limited circumstances.[13] But, even in preference to TNMM, Revenue Canada would prefer profit-split approaches and, in particular, residual profit split rather than straight profit split.

   Taxpayers can try to rely on either documentation, or competent authority, to resolve issues that might arise. Alternatively, taxpayers, in the Canada-U.S. context, may wish to avoid all of the uncertainty and negotiate APAs between the two countries.

3. Reason #3: The Risk of Penalties Even...