The implications in and for Canada of the IRS's final section 482 services regulations.

• Author: Boidman, Nathan

Overview

In principle, there ought to have been no need to write this article. The reasons are threefold. First, the principle underlying the tax rule governing cross-border intercompany transactions in Canada and the United States is the same: namely, intercompany prices are to be governed by the arm's-length standard. In the United States, this is expressed in the regulations pursuant to section 482 of the Internal Revenue Code. (1) In particular, Treas. Reg. [section] 1.482-1(b)(1) states, in part:

The purpose of section 482 is to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer, by determining, according to the standards of an uncontrolled taxpayer, the true taxable income from the property and business of a controlled taxpayer .... The standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer. (2) Canada's standard is contained in the basic intercompany transfer pricing rule of section 247(2) of the Income Tax Act, (3) which states:

Where a taxpayer or a partnership and a non-resident person with whom the taxpayer or the partnership, or a member of the partnership, does not deal at arm's length (or a partnership of which the non-resident person is a member) are participants in a transaction or a series of transactions and (a) the terms or conditions made or imposed, in respect of the transaction or series, between any of the participants in the transaction or series differ from those that would have been made between persons dealing at arm's length .... any amounts that, but for this section and section 245, would be determined for the purposes of the Act in respect of the taxpayer or the partnership for a taxation year or fiscal period shall be adjusted (in this section referred to an "adjustment") to the quantum or nature of the amounts that would have been determined if, (c) where only paragraph (a) applies, the terms and conditions made or imposed in respect of the transaction or series, between the participants in the transaction or series had been those that would have been made between persons dealing at arm's length...." (5) Second, credible recognition has been to the hegemony of facts and circumstances in applying the arm's-length standard principle. This was seen some 47 years ago in a 1962 decision of the Tax Review Board of Canada in Hofert (6) (involving sales of Christmas trees by a Canadian subsidiary to its U.S. parent), where the Tax Review Board stated that proper pricing is simply a matter of the particular facts and circumstances of the case. Some 30 years later, in September 1992, then-acting U.S. Treasury International Tax Counsel, James Mogle, in announcing that the U.S. Department of the Treasury and Internal Revenue Service were withdrawing from the proposed section 482 regulations (which had been issued in January of that year) the "comparable price method" (CPM) as a mandatory method, was quoted, as follows:

Mogle said he has "a few ideas" as to what might replace CPI, but gave no details. The right answer, he believes, is "a great deal more flexibility and broad principles from which you can then go to a fact and circumstances analysis." (7) Thus, the arm's-length principle is a matter to be determined according to the particular facts, ultimately, by a court and, per se, its determination should not be the object of any specific "rules." (8)

Unfortunately, in 1968, the United States started to ignore, overlook, or compromise this fact of legal life when the government issued the first set of regulations under section 482. The problem spread to other parts of the world with the issuance of the OECD's 1979 "guidelines," (9) which were more or less a knockoff of the 1968 U.S. Regulations.

Third, again in principle, are not intercompany services basically susceptible to reasonably straightforward and uncontroversial treatment under the arm's-length standard, in contrast to intercompany sales of proprietary products or intercompany licensing of proprietary intangibles, as transactions that do not necessarily involve high-value intangibles?

Notwithstanding these principles, there is a need to write this article for five reasons.

First, international intercompany transfer pricing has increasingly become distorted by a de-emphasis of the arm's-length standard as a rule of law and growing emphasis of it as a mechanical apparatus to be sliced and diced and dealt with in modules, as though varying facts and circumstances never existed. (10) Although this really started in 1968, it picked up steam some two decades later with the issuance by the U.S. Treasury and the IRS of the White Paper, written pursuant to the enactment in 1986 of the "super royalty" amendment to section 482. (11) Any examination of that voluminous document shows a laboratory-like approach to dealing with the facts and circumstances, though it was with some substantial relief that one came to the conclusion that where more than one member of a group owned high-valued intangibles, the laboratory-like allocation method suggested by the White Paper came down to a profit-split, which is reality but a judgment call. (12)

After that, the flurry of activity by the United States and other countries (whose efforts have been galvanized around the work of the OECD) has more and more led to a disconnect between the essential nature of the arm's-length standard, and the mechanical way in which legislators and administrators believe that they can try to deal with it. This unfortunate factor permeates all developments in transfer pricing including the new U.S. Services regulations under section 482.

The second reason is the almost paranoid fashion in which tax administrators view the activities of multinationals--the concern that transfer pricing is used as sword that seeks to manipulate prices in order to allocate profits in a fashion that reduces overall group tax. This leads to the constant, debilitating process, of trying to either fine tune or add radical elements to what at law is a principle that simply cannot be put into a nice, neat box. Therefore, there are the ongoing studies by the OECD of "business restructuring" (13) and the "revelations" in recent proposals to revise Chapters I, II, and III of the OECD Guidelines. (14) The nexus noted earlier between OECD and U.S. Regulations has been vividly brought to mind by the OECD proposals, which would essentially jettison the hegemony of "traditional" transactional methods over "profit-based" methods. The OECD's September 9 release trumpets how experience since 1995 indicates that there should no longer be a bias toward (or a presumption in favor of) "the traditional methods" (based on pricing each transaction) over the "transactional profit methods" (which are not really pricing methods at all but rather tax authority techniques for evaluating the extent to which the "arm's length pricing" standard has been met). As a result, the release states there should be "a standard whereby the selected transfer pricing method should be the 'most appropriate method to the circumstances of the case.'" Is not that the U.S. 1994 "best method" rule? (15)

The third reason is the vivid contrast between the approaches of Canada and the United States to legislatively applying the arm's-length standard. For Canada, the matter is simple. The law is the standard and nothing but the standard. (See section 247(2)(a) of the Act.) There are no statutory regulations. (16) Jurisprudence on services has simply confirmed the notion that it is all a question of the facts and circumstances of a particular case. (17) There are a plethora of views, interpretations, and positions of the Canadian Revenue Agency (CRA) on transfer pricing (18) that simply do not make law. (19) And yet, somewhat surprisingly, (20) Canadian courts have suggested that the OECD materials (and, in particular, the OECD Model Treaty and the OECD Transfer Pricing Guidelines) are sources that a court may take into account in dealing with the particular issue before it. (21)

The United States, on the other hand, has had regulations since 1968 and, with respect to "'services," there are the new July 31 final regulations which are voluminous (running to 158 pages) and detailed. (22) This article focuses on the effect of those rules in and on Canada.

Fourth, there is the difficulty that the notion of "services" as used in a plain, generic, commercial context--that is to say, one person renders a service to another--in fact masks the range of factors that may arise under that term. In particular, this area of intercompany relations (as dealt with in the new regulations and that are addressed by the CRA in its writings and by the OECD in its musings) extend far beyond the notion of a consenting person with the ability to render a service in fact rendering that service to another consenting person with ability to contract and receive the service.

Included as well are the following factors and elements, which give this area much of its difficulty, complexity, and controversy. There is a question of the nature of the business deal and relationship where the arrangement is not simply a service by one person to another, or one member of the group to another, but rather a de facto or legal sharing of an employee. This may also raise the difficult question of "secondments," the boundaries and full implications of which may be less than clear under contract or employment law, quite apart from the issues arising under tax law. (23) Separately, there is the different question (in relation to the notion of intercompany services) whether a particular activity carried out by one corporation (generally, a parent) provides a service (with a monetary value) to another member (say, a subsidiary) as opposed to being carried out for the purposes and benefit of the parent. This, of course, is the issue of "shareholder" or stewardship or custodial...