Canadian transfer pricing rules keep pace with international developments.

• Author: Wilkie, J. Scott

The transfer pricing rules in the Canadian Income Tax Act (the Act), and Revenue Canada's practices in applying them, are being modified to more closely reflect the "arm's length principle" as articulated by the Organisation for Economic Co-operation and Development (OECD), and to conform to and adopt by reference the revised transfer pricing guidelines(1) announced by the OECD in stages beginning in July 1995 (the OECD Guidelines). Canadian transfer pricing rules and practices have consistently assimilated and been applied according to the arm's length principle and associated analytical and methodological guidelines(2) as set out by the OECD. Broadly, the reported income of Canadian taxpayers engaged in transactions with other members of controlled groups of which they are members in circumstances that are integrated functionally is measured with reference to transactional terms and conditions, including pricing, that would have been present in the absence of organizational and other unique relationships among the parties to the transactions. The changes, which do not substantially alter Canadian transfer pricing rules and practices, continue Canada's adherence to this principle, but in a more contemporary fashion. These changes mirror recent developments internationally but perhaps most notably in the United States.

Importantly, the changes to the Act(3) include a specific penalty for deficiencies in reported income arising from insupportable and undocumented transfer pricing. Also included is a statutory requirement that transactional transfer prices be described in a materially "complete and accurate" manner in contemporaneous documentation, prepared when pricing determinations are made, that analyzes these determinations with reference to the corporate organizational, functional, and economic context in which transactions occur. The changes also expand the foreign reporting rules with respect to transactions between Canadians and non-residents, primarily to ensure that transactions involving partnerships and their members fall comprehensively within the ambit of these rules.

The legislative changes are included in a Notice and Ways and Means Motion to amend the Act (the Notice) tabled by the Minister of Finance in the House of Commons on December 8, 1997, and now Bill C-28, which was given first and second reading in the House on December 10, 1997, and February 4, 1998, respectively. The Notice introduces section 247 into the Act as the contemporary statutory embodiment of Canada's transfer pricing rules, replacing its precursor in subsections 69(2) and 69(3) of the Act. In addition, the foreign reporting rules in section 233.1 of the Act are amended. The transfer pricing changes in the Notice replace an earlier version released on September 11, 1997, accompanied by a draft of proposed Revenue Canada Information Circular 87-2R (the "Draft Circular," a revision of Revenue Canada's longstanding statement of its administrative practice in this area). A variety of constructive modifications were made to the September 11 draft to reflect comments offered by taxpayers and their professional advisers. The Draft Circular remains subject to public comment and revision, but is expected to be released in its final form in 1998.

The new rules apply generally to taxation years or fiscal periods beginning after 1997,(4) although the penalty and its supporting rules, including the new contemporaneous documentation requirements, do not apply until taxation years or fiscal periods beginning after 1998 and in any event do not apply to transactions completed before September 11, 1997, when the rules first were announced in draft form.(5)

An Overview of the New Rules

Section 247 has three main elements: a statutory expression of the arm's length principle as the basis on which adjustments to income and the cost of property may be made'(6) a specific transfer pricing penalty;(7) and documentation requirements that, if not satisfied at a threshold level, will engender the imposition of the penalty(8) in respect of adjustments to income and the tax cost of property.

A. The Arm's Length Principle and Adjustments

Subsection 247(2) sets out the statutory basis for adjusting income with reference to an arm's length analogue -- effectively a contemporary incorporation in the Act of the OECD's formulation of the arm's length principle. It applies on a transaction (or series of transactions) basis and calls for adjustments to the "quantum or nature" of amounts where either transactional terms and conditions are different from those for transactions between arm's length parties,(9) or the transaction (or series) itself would not have been undertaken by arm's length parties and is primarily tax-motivated (i.e., "can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit").(10) In the first case, an adjustment will be based on the terms or conditions of a transaction that arm's length parties would have adopted. In the second, the revenue authorities are authorized to redetermine amounts based on the transaction that arm's length parties would have implemented on arm's length terms -- in other words to make the transfer pricing determination with reference to a substituted transaction rather than the actual transaction.(11)

Subsection 247(2) is a broad, descriptive formulation of the arm's length principle. Despite the adoption for other purposes in section 247 of definitions of "arm's length transfer price"(12) and "transfer price,"(13) which embellish the arm's length principle by referring to the kinds of transactions that may be affected, subsection 247(2) is not so limited and in fact does not mention transactional pricing (though it does have a transactional orientation). Neither does it directly apply any reasonableness standard to the adequacy of transfer pricing determinations in affected circumstances. Although such a standard is probably implicit in the nature of transfer pricing analysis and the analytical methods commonly adopted for evaluating pricing and the implications of how they should be applied, the elimination of a specific statutory reference to such a test, as found in existing subsections 69(2) and (3) of the Act, makes this expectation less clear than would be desirable. The restatement of the transfer pricing rules without this qualification raises a question whether the restated rules allow less for the inherent imprecision of transfer pricing analysis than did its predecessors.

The Draft Circular contains, as before, the methodological basis for determining the adequacy of and adjusting transfer pricing. Revenue Canada's general expectation that pricing determinations reflect the application of a transactional method ("comparable uncontrolled price," "cost plus," and "resale minus"), rather than a profit split or comparison, continues and, if anything, is more clearly stated, although to much the same effect as in the existing administrative practice.(14) Relying substantially on the OECD Guidelines(15) the Draft Circular reiterates the importance attached by Revenue Canada to evaluating transfer prices by reference to comparable transactions of the tested taxpayer with arm's length parties ("internal comparables") or of third parties at arm's length with each other ("exact comparables").(16) In short, Revenue Canada continues to express a strong preference for an analysis grounded in a "comparable uncontrolled price," but in any event supported by either of the other two traditional methodologies, "cost-plus" and "resale-minus."

Nevertheless, there is cautious recognition(17) of the transactional profit methods--residual and contribution profit-split, and the "transactional net margin method" (TNMM) developed as part of the OECD Guidelines (and, in the minds of some, very similar in concept to the U.S. "comparable profit method" (CPM))--that are acknowledged in a similarly guarded fashion in the OECD Guidelines.(18) Revenue Canada expresses a preference for a residual profit-split approach, rather than one based on relative contributions of the parties to an enterprise that includes the affected transactions, and clearly considers a profit-split approach to be superior to any kind of marginal or comparative profit analysis recognized in the guise of the TNMM, which is expressly considered to be a method of last resort. Indeed, the Draft Circular echoes the OECD's view that these profit-based methods are intrinsically transactional. This assertion seemingly gives a transactional connotation to the profit-oriented approaches and therefore draws them closer to the typical methodologies by requiring that transfer prices among non-arm's length parties be defensible by reference to comparable transactions and circumstances of independent counterparties. The application of profit-split methods, in principle, is confined by the stated expectation that they will only be useful where there is a considerable degree of corporate integration in the affected group of which the Canadian taxpayer is a member and a high degree of transactional comparability in relation to the data and circumstances referenced in a profit-based analysis.(19)

Subsection 247(2) replaces subsections 69(2) and (3) of the Act, which permitted amounts received to be increased and payments made to be decreased, in respect of various transfers of property and the performance of services involving arrangements between Canadian residents and non-residents. These provisions allowed for adjustments to conform to what "would have been reasonable in the circumstances if the non-resident person and the taxpayer had been dealing at arm's length...for the purpose of computing the taxpayer's income...." Although Revenue Canada has consistently characterized this formulation of the arm's length principle as a mere reiteration of the OECD version, and accordingly insisted on...