Recent developments in Canadian transfer pricing.

• Author: Boidman, Nathan

1. Overview

   This article reviews three recent developments respecting Canadian transfer pricing law and practice. Two concern transfer pricing-related penalties, and the associated notion of preparing contemporaneous documentation; and the third deals with taxpayer-initiated downward adjustments related to excessive inbound prices or insufficient outbound prices.

   Canada, like the United States, regulates cross-border intercompany transactions on the basis of the "arm's-length principle," rejecting (like most other countries) the alternative of formulary apportionment law and methods. (1) In light of the facts-and-circumstances nature of the principle, the Canadian tax statute does not lay down (directly or through statutorily-authorized regulations) any implementing rules, (2) in contrast to the United States whose governing "regulations" were promulgated pursuant to section 482 of the Internal Revenue Code. (3) In the absence of specific statutory rules for applying the arm's-length principle, Canada Customs and Revenue Agency (CCRA) takes the position that determinations are to be made in accordance with the transfer pricing "methods" developed (mainly on the basis of the U.S. regulations) by the Organisation for Economic Cooperation and Development (OECD). (4) This CCRA view is set forth in a non-binding "information circular." (5)

   With effect for the 1999 taxation year, Canada has followed the lead of the United States (some three years earlier) by adopting specific transfer pricing-related penalties, with the associated notion that the timely preparation of contemporaneous documentation may provide a safe harbor from such penalties. (6)

   In light of the subjectivity--and hence uncertainty--stemming from the facts and circumstances nature of the basic "rule," it is not surprising that (1) there have been no court decisions in either country since 1962 involving a Canada-U.S. transfer pricing issue, (2) generally, disputes involving Canada and the United States are either resolved at domestic audit or through competent authority procedure, and (3) in the early 1990s (again at the initiative of the United States) both Canada and the United States (and both then and later, many other countries) have tried to take the uncertainty out of the equation by agreeing, in advance of disputes, through advance pricing agreements. (7)

   Even in areas where Canada and the United States are ostensibly at odds, the unifying effect of the essential character of the principle has substantially tempered such differences. In particular, since 1992 the United States. has ostensibly been lined up against Canada, and the balance of the OECD, respecting the role of CPM. Nevertheless, the almost twin cousin developed by the OECD (the net transactional margin method (TNMM)) has not only mainly dissolved the conflict, but in its September 1999 revised information circular, CCRA reluctantly acknowledged that in some circumstances CPM (and not merely its twin TNMM) might be appropriate. (8)

   Although there are several other factors that could be considered to be part of Canadian transfer price law and practice, the foregoing should serve to provide an adequate framework to consider the three recent developments in Canada.

2. Recent Developments Related To Penalties And Documentation

   1. Background

      With effect in 1999, there is a transfer price related penalty, equal to 10 percent of the amount by which Canadian income has been understated because of transfer prices not conforming to the arm's-length principle. (9)

      The penalties can only apply (with respect to transactions on current account) where (1) income has been understated by an amount exceeding the lesser of CDN$5 million or 10 percent of the gross sales (of goods or services) of the relevant Canadian party, and (2) the taxpayer did not make "reasonable efforts" in arriving at those "wrong" transfer prices. (10) In contrast to the United States, the penalty can apply, regardless of whether there is taxable income in the year.

      As in the United States, there is no positive statutory test respecting "reasonable efforts," (11) but the requirements will be deemed not to been satisfied 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 year end), "records or documents" (i.e., documentation) as set out in section 247(4) of the Act. Preparing such documentation, however, does not automatically mean the taxpayer will be considered to have made "reasonable efforts."

   2. PATA Agreement on Documentation

      On March 12, 2003, the Pacific Association of Tax Administrators (consisting of Australia, Canada, Japan, and the United States) released a package of transfer pricing-related documentation rules, which are intended to minimize the cost and burden of preparing multiple documentation otherwise required under the domestic law of each of the four countries. Although the PATA rules intimate that compliance with the documentation requirements will serve as a guarantee against transfer price related penalties, the "small print" of the rules disabuses the reader of that possibility, at least from the Canadian standpoint.

      Before the PATA agreement, there was clearly a question in Canada whether such documents prepared for purposes of another country (often the United States) would be acceptable in Canada. One difference between the two countries, for example, is that the Canadian requirements fall into six categories whereas the U.S. approach is delineated between principal documents and background documents, entailing ten categories. It is the burden of preparing multiple sets of documents under differing rules in respect of the same transaction that prompted PATA members to negotiate an agreement that will permit a multinational operating in two or more of these countries to prepare a "single package" of documentation related to relevant intercompany transactions. This initiative should decrease the compliance costs of multinationals operating within the four countries. But there is one problem with the package.

      Aspects of its language suggest that taxpayers utilizing the PATA documentation package will have certainty that they will not be exposed to penalties, even if their prices are wrong. That would change the result in Canada, inasmuch as documentation prepared in accordance with section 247(4) of the Canadian Income Tax Act does not, by itself, provide a safe harbor against penalties. As previously explained, section 247(4) requires both that and the making of "reasonable efforts," which itself is a subjective matter. This implication of certainty comes out of the following language in, and related to, the package.

      A CCRA press release (12) announcing the March 12 PATA agreement, states:

      The PATA documentation package is intended to reduce taxpayer burden and provide certainty that a penalty will not be imposed. Use of this PATA documentation package is completely voluntary and, if the principles are satisfied, will protect the taxpayer from transfer pricing documentation penalties that might otherwise apply in each of the four jurisdictions. (Emphasis added.) Similarly, the Introduction to the agreement itself provides:

      The PATA members, after reviewing their respective domestic laws regarding transfer pricing and documentation of controlled transactions, agree that a multinational enterprise ("MNE") will satisfy each PATA member's documentation provisions by complying with all of the principles contained in this PATA Documentation Package, and will thus avoid the imposition of the PATA members' transfer pricing penalties with respect to the documented transactions among associated enterprises resident in PATA member jurisdictions. By providing taxpayers with the option of applying this uniform documentation package, the PATA members intend to assist taxpayers to efficiently prepare and maintain useful transfer pricing documentation, and timely produce such documentation upon request to PATA to member tax administrations while precluding any related transfer pricing penalties. (Emphasis added.) The implication of these statements is that...