The Canada-United states tax regime.

• Author: Groetzinger, Jon
• Position: PROCEEDINGS OF THE CANADA-UNITED STATES LAW INSTITUTE HENRY T. KING, Jr. ANNUAL CONFERENCE on THE CANADA-UNITED STATES REGULATORY REGIME: REVIEW, REFORM, RECOVERY: Cleveland, Ohio: April 8-10, 2010

Session Chair--Jon Groetzinger

United States Speaker--E. Miller Williams

Canadian Speaker--Jeffrey Shafer

INTRODUCTION

MR. GROETZINGER: Good morning to everyone. Thank you for coming out bright and early on a Saturday morning for seventy-five minutes of tax updates. Quite appropriately, we have five days left to get our tax returns in or file for extensions. It is always a great time of year.

Today we have two speakers who will give us an update on the United States-Canada Tax Treaty and transfer pricing issues. Jeffrey Shafer is an associate with Blake Cassels in Toronto. (1) A former mechanical engineer educated at the University of Waterloo, he has become a tax lawyer and has won many awards.

Miller Williams is from Ernst and Young out of Atlanta, Georgia (2) and is an expert in transfer pricing issues and advance pricing agreements. We will start today with Mr. Williams and his discussion about advance pricing agreements.

UNITED STATES SPEAKER

E. Miller Williams *

MR. WILLIAMS: Good morning, and I thank you for the opportunity to talk with you about transfer pricing, specifically as it relates to the United States-Canada Income Tax Treaty, (3) advance pricing agreements, and the arbitration provisions of the Treaty (4) that have recently come into play.

In terms of today's agenda, let me just provide a basic background on transfer pricing. Transfer pricing is how companies transfer goods, services, and intellectual property among their related or affiliated groups of companies around the world. (5) It is very important because, based on this pricing, if you have a significant amount of intercompany transactions for a particular legal entity or consolidated group of taxpayers in a country, it will lead to profit for that company; profit, in turn, will determine a company's taxable income.

From a tax authority standpoint, determining the value of this transfer pricing is extremely important because it will ultimately determine the amount of tax that must be paid. Transfer pricing, based on a number of surveys done by Ernst and Young and other accounting firms, is really the most important international tax concern for our clients who are large, multinational companies. (6)

Transfer pricing is a very subjective area. There are not many black and white answers in the transfer pricing field. We have lawyers, economists, and business people working together, trying to make transfer pricing as scientific or quantitative as possible. In reality, however, it is very subjective; it is based on the particular facts and circumstances of the transactions and tax payers.

A lot of planning goes into transfer pricing; you want to be able to set in advance the functions and risks of a legal entity in order to assist in analyzing the transfer pricing. This pricing is based on the arm's-length standard, or how two parties would negotiate in terms of the transfer price. (7) This may be different from what you are familiar with for state corporate income tax purposes. In the United States, some states have an arm's-length principle (8) while most have an apportionment principle. (9) The apportionment principle looks at the profits of a United States company; these total profits are then divided into each state based on things such as sales, assets, or wages that are in that particular state. This carves out what should be the state taxable income. That is different from the arm's-length principle. The arm's-length principle has been used in the international area by the Department of Treasury, (10) the Organization for Economic Cooperation and Development (OECD), (11) and foreign governments around the world. (12) The transfer pricing guidelines of these organizations have all affirmed the arm's-length standard as opposed to the apportionment standard. Generally, with the exception of Brazil, most of the countries follow the arm's-length standard. (13)

To give you an example, say we have a United States company that makes widgets, and it sets up a distributor in Canada. The company sells the widgets to the distributor in Canada, and the distributor sells the widgets to customers. If the United States company sells the products to the distributor at a high price, and if after adding selling and startup costs to this price the total costs are greater than the price for which the product is sold, then the company will end up with a loss. In that example, the question is really a matter of which company bears that startup cost in terms of setting the price. Should the United States sell it at a lower price, allowing Canada to resell it and make a profit? This is an example of what we are talking about in terms of the pricing, whether it is a United States company selling in Canada or a Canadian company selling in the United States to its related subsidiary in the other country.

It could also be a situation of intellectual property--whether it is a patent, copyright, or trademark being charged up to the Canadian manufacturer. Also, if you have a United States-based retailer that has set up stores and then goes up to Canada and begins to set up more stores, what should they charge for the use of the name? Or it could be the system of operations that is being sold or relationships with vendors, or even services rendered by the United States company for the benefit of the Canadian company. All of these come into play when dealing with transfer pricing. (14)

What if you have two plants--one in Canada and the other in the United States--that are making product, and the American parent company decides to close the Canadian company? Who should bear all of the restructuring costs in this situation? These are a number of the issues that arise with transfer pricing.

As you can see, both parties, the Canadian side (15) and the Internal Revenue Service (IRS) (16) side, have transfer pricing rules in place. There are also penalty provisions in place in both countries. (17) Canada's penalties are actually more severe in some respects. For example, there is a ten percent penalty in Canada on the amount of adjustment, (18) whereas in the United States, the penalty is on the amount of additional tax paid. (19)

We also now have Financial Accounting Standards Board Interpretation Number 48 (FIN 48) provisions for companies in terms of assessing their taxes, (20) which provides greater certainty in assessing transfer pricing. To give a basic explanation, the United States IRS has asked for disclosure on the tax returns going forward of all uncertain tax positions, (21) as well as the FIN 48 positions of companies. (22) I think we are going to see a lot more controversy around this because of those provisions.

One of the ways to minimize transfer pricing issues is through the use of bilateral Advance Pricing Agreements (APA). (23) We are going to talk about that in detail, and I will try to specifically relate it to the United States and Canada. I will also discuss the steps that need to be taken to successfully negotiate an APA in addition to the competent authority provisions or mutual agreement procedures that we have in income tax treaties around the world, specifically for Canada and the United States. These provisions are designed to prevent double taxation, (24) and, from a transfer pricing standpoint, that can be considered a success. In other words, success could mean a company ends up paying tax on profits due to transfer pricing in only one jurisdiction. Perhaps the ultimate success, however, is when companies are actually able--through transfer pricing functions, risk, and alignment--to put the profit into a low-tax jurisdiction.

But when dealing with Canada and the United States, two high-tax countries, (25) it may just depend on each company's situation. Several different factors come into play such as losses, financing arrangements, or use of foreign tax credits. (26) In terms of United States and Canada, many times you are just trying to arrange a situation in which a company is not subject to double taxation.

Sometimes you have other countries with a low tax that do come into play. For example, the United States could be licensing know-how to a related party in Ireland, and then the party in Ireland sells product into Canada, and maybe Canada makes an adjustment on the transfer pricing. How do you deal with these issues among multiple countries? One of the issues that has come up over the years in competent authority is how the two governments can be forced to come together to reach an agreement. This may be difficult, because each country may want to put more taxable income into their respective locations. To solve this problem, there are what we call the arbitration provisions. The United States has this type of provision in only a couple of treaties, perhaps in those with Germany, (27) Belgium, (28) and Canada. (29) We will talk about these arbitration provisions, but the idea is that if a case cannot be settled in a reasonable amount of time, it will be pushed into the arbitration procedure to be settled. The goal, of course, is to never have to resort to the arbitration procedures.

In terms of developing transfer pricing, it is really a life cycle of planning that involves analysis, compliance, and then documentation.

When we talk about documentation, we mean the actual transfer pricing studies (30) and how they are presented on tax returns. Both countries have proper forms for this procedure. Canada has a T106 form, (31) and the United States has forms 5472 or 5471. (32) On these forms, a company must list the related party transactions; (33) in addition, the Canadian forms specifically ask whether there is documentation in place at the time of filing the tax return. (34) Throughout this process, a company must also check to ensure that its policy is being followed, and, at the end of the year, a company may have to make what is called a "compensating adjustment" to adjust the transfer pricing to bring it in line...