Canadian release increases fears of U.S.-Canadian transfer pricing disputes.

• Author: Borraccia, Salvador M.

1. Introduction

   On January 7, 1994, Canadian Finance Minister Paul Martin and National Revenue Minister David Anderson issued a News Release clarifying the application of the Canadian income tax rules and guidelines for determining transfer prices between members of an international corporate group. The Release, which was issued in response to U.S. transfer pricing developments, raises serious questions about the potential for double taxation in Canadian/U.S. cross-border pricing matters.

   For some time, senior Canadian government officials have expressed concern about the potential for double taxation and the possible inability to resolve intercompany pricing disputes with the United States in light of the 1993 temporary and proposed regulations under section 482 of the U.S. Internal Revenue Code/ This, coupled with the comments made by the Organisation for Economic Cooperation and Development in its December 1992 and April 1993 reports, has heightened concern in Canada.

2. Canadian Transfer

   Pricing Principles

   In international transactions between related parties (and other persons not dealing at arm's length), the Canadian Income Tax Act (ITA) requires that the amount paid or received be an amount that "would have been reasonable in the circumstances if the nonresident person and the taxpayer had been dealing at arm's length."(3) The ITA, however, does not provide any guidelines or tests. The administration and enforcement of these provisions are left to the Department of National Revenue (Revenue Canada)(4) and, ultimately, to the Canadian courts. Reasonableness is a question of fact. Few Canadian cases have gone to court and, accordingly, there is little law on which to rely. The Canadian approach, however, does leave open the application of all factors. To the extent that the U.S. regulations restrict or limit the factors that may be brought into account or impose a non-arm's length type of test, there may be conflict between the Canadian and U.S. rules.

   Administratively, Revenue Canada has adopted the 1979 OECD guidelines(5) and, in respect of transfers of tangible property, has looked to the comparable uncontrolled price (CUP) method, the resale-price method, the cost-plus method, and other methods. Other methods typically follow a functional analysis and can involve profit splits. There is no priority given to any particular method, except that CUP is normally applied if reasonably comparable transactions are available.

   In respect of intangible property, IC-87-2 outlines methods that essentially mirror those in the pre1993 U.S. regulations(5) and, absent a comparable uncontrolled transaction, suggests a consideration of all factors, including prevailing rates in the industry, terms of the license, singularity of the invention, services provided, anticipated profits to be received by the licensee, and benefits to the licensor from sharing information on the experience of the licensee.

3. Tensions Between Canadian

   and U.S. Rules

   Against this background, there are a number of potential conflicts between the Canadian rules and the U.S. regulations that must be considered. One of the most basic is the regulations' focus on the results of a transaction rather than whether an unrelated party would have entered into the transaction. To a significant extent, the U.S. regulations look to the former and Canada has typically focused on the latter.(7) Because the U.S. approach involves hindsight , it arguably deviates from the arm's-length standard.

   The second potential conflict relates to the ability to use various methods in the regulations. While the "best method rule''s is the general standard, there are a number of circumstances where taxpayers will be compelled to use the comparable profits method (CPM) rather than one of the OECD-sanctioned methods. For example, the CUP method may be used when it is reasonably applied on the basis of available information and there are only minor (ie., immaterial) differences between the controlled and uncontrolled transactions. Thus, "material" differences invalidate this method, even if their effects on price can be reasonably ascertained.(9) Use of this method is also excluded where there are speculative differences...