Transfer pricing audits
Mandatory arbitration


Transfer pricing attracts a lot of attention from tax authorities, generally because large amounts are often involved and most countries are concerned with protecting their own tax base.

Transfer pricing refers to the manner in which prices for goods and services are determined among entities within the same corporate group and in different countries. In general, where a corporate group has one entity in a country acquiring goods and services (eg, raw materials, inventory, royalties for the use of IP or finance-related services) from another entity in a different country, the price that they agree to pay for those goods and services (the 'transfer price') affects how much income is realised (and therefore how much tax is paid) in each country.

As different countries have different tax rates, there is an incentive to have an entity in the higher-tax country incur more expenses (ie, pay higher transfer prices for goods and services received) and minimise income (ie, charge less for services rendered or goods sold) on transactions with a group member in a lower-tax country. To control transfer pricing, the tax systems of advanced countries generally have rules which effectively adjust the price to an 'arm's-length' price where an entity in that country has paid too much or charged too little for goods and services in a transaction with a non-arm's-length entity in another country.

Canadian tax authorities are aggressive in challenging taxpayers on transfer pricing. Transfer pricing audits can take up a lot of time and resources, even if the taxpayer is ultimately successful. One of the biggest dangers for taxpayers is that the tax authorities of the two countries involved (eg, Canada and the United States) may not agree on what the 'correct' arm's-length price is for a transaction between affiliates in each country and, in those circumstances, double tax results. For example, Canada may allow the Canadian entity a deduction for only $50 million even though it paid $75 million to a related US entity, while the United States treats the US entity as having received $75 million of income. In the case of Canada-US transfer pricing disputes, that problem may potentially be alleviated under new mandatory arbitration rules which were added by the most recent protocol to the Canada-US Income Tax Convention.

On February 28 2012 the Canada Revenue Agency (CRA) and Professionals Consultation Group hosted a seminar at which a panel of speakers from the CRA and private practice discussed what to expect from a transfer-pricing audit and how best to manage the process and achieve a favourable outcome. The panel also discussed the new mandatory arbitration rules in the convention. The following discussion summarises and highlights key points of the two panel discussions.

Transfer pricing audits

The local CRA tax services office serving the taxpayer will conduct the transfer pricing audit. Generally, the audit process consists of three stages: research, analysis and resolution.

At the research stage, the CRA auditor's goal is to:

  • understand the taxpayer's business and how it functions within its corporate group;
  • determine where business value is added and by which entities in the group; and
  • identify suitable comparables within the taxpayer's industry.

Generally, the auditor will assemble the audit team and have an initial meeting with the taxpayer to present the audit plan and to request formally the taxpayer's contemporaneous transfer pricing documentation pursuant to the transfer pricing rules in Section 247 of the Income Tax Act. Once the CRA has made the request, the taxpayer has three months to provide its contemporaneous documentation.(1) Taxpayers must keep in mind that this is a hard deadline and that the CRA will not extend it. Penalties may apply if a taxpayer does not maintain sufficient contemporaneous documentation as required.

The CRA audit team will request, gather and review tax, financial and other information related to the taxpayer and other members of its corporate group (whether Canadian or foreign). Typically, the CRA's information requests are detailed and wide ranging, with the CRA requesting (in addition to corporate books and records) organisational and staff charts, documentation from foreign tax authorities (and other foreign-based information) and business plans. The CRA may also ask the taxpayer to generate information that it does not normally keep. The authority granted to the CRA under the Income Tax Act to obtain information from taxpayers is broad, but there are limits. For example, the CRA cannot legally compel the taxpayer to provide information that is protected by solicitor-client privilege.

The CRA will also conduct interviews and site visits with key officers and employees. The costs relating to site visits are often a contentious issue: generally, site visit costs for visits outside of Canada are borne by the taxpayer. Taxpayers should be aware that the auditor will also look at the taxpayer's marketing and other business or promotional material (including information provided on its website) to determine whether the description of the services provided by the taxpayer is consistent with its transfer pricing, tax and financial documentation. Often, the CRA will look closely at such assets as R&D and intangibles within the group.

During the panel discussion, the CRA panellists emphasised that it is generally in the taxpayer's interest to provide the agency with sufficient information to allow it to perform a principled and efficient transfer-pricing audit.

At the analysis stage, the CRA will review the taxpayer's transfer pricing analysis and all available supporting documentation and conduct its own transfer pricing analysis, which will include evaluating comparable taxpayers and/or transactions, if any. In reviewing the taxpayer's transfer pricing analysis, the CRA will examine the entire value chain within the corporate group, including margins at each level, as well as consistency (or variance) in cost methods and comparables used in relation to functions, assets, risks and other business factors. In evaluating comparables, the CRA can draw on multiple sources, including its extensive database and library of information on Canadian taxpayers, as well as industry knowledge.

If the CRA identifies deficiencies in the taxpayer's transfer pricing analysis, those should normally be addressed in the CRA's own transfer pricing analysis of the taxpayer's business. During the analysis, the audit team may assign an economist to the audit file if required; it may also obtain the assistance of other specialists within the CRA and, in certain circumstances, seek advice from external industry specialists. Generally, if the economist's analysis supports the auditor's position, the CRA will not deviate from that position.

At the resolution stage, the CRA will issue a 30-day proposal letter informing the taxpayer how it intends to reassess for the year(s) at issue. If the transfer pricing assessment exceeds a specific minimum threshold, the auditor will automatically include in the proposal letter a transfer pricing penalty determined pursuant to Section 247(3) of the Income Tax Act. As the penalty does not apply if the taxpayer has made reasonable efforts to determine an arm's-length transfer price, the taxpayer will generally want to ensure that the CRA has sufficient facts at this stage to support the conclusion that the taxpayer has made such reasonable efforts.

This stage also provides the CRA and the taxpayer with the opportunity to discuss any unresolved issues, make further submissions and provide/receive clarification on any outstanding questions. If the taxpayer experiences a problem with the auditor that cannot be resolved, the taxpayer should work up the management chain at the local tax services office to resolve it, as the CRA's headquarters does not normally deal with audits.

The CRA generally does not negotiate transfer pricing cases at the audit stage. Negotiations usually will not begin until the case proceeds to the appeals level at the CRA or to the mutual agreement procedure stage under a relevant tax treaty.

Overall, the CRA's audit process and resolution will be driven by any applicable statute of limitations for reassessments under a relevant tax treaty with Canada. For example, under the Canada-US Income Tax Convention, if Canada issues a transfer pricing reassessment to a Canadian taxpayer, it generally must notify US tax authorities of the reassessment within six years of the end of the affected taxation year of the taxpayer.

Mandatory arbitration

Canada's first mandatory arbitration provision, contained in the Canada-US Income Tax Convention, took effect on December 15 2008; before that date, arbitration was available only if the two countries' tax authorities voluntarily agreed to it. Typically, the tax authorities of Canada and the United States meet to negotiate double tax cases under the convention's mutual agreement procedure four times per year and usually take about three negotiation sessions to resolve a case (if it is resolved).

Under the convention's mandatory arbitration provision, certain tax disputes that cannot be resolved within two years are subject to mandatory arbitration if the taxpayer requests it. The tax authorities can also mutually agree to accelerate a taxpayer's right to arbitration where resolution of a dispute is unlikely, or to delay the arbitration if ongoing mutual agreement procedure negotiations remain productive.

Mandatory arbitration is generally available for disputes relating to the existence of (and attribution of profits to) a permanent establishment, royalties and residency for treaty purposes, as well as to unresolved Canada-US advance pricing agreement cases. However, Canadian and US tax authorities have some discretion to include or exclude cases from arbitration. Interest on unpaid tax and penalties are outside the scope of arbitration.

The CRA and the Internal Revenue Service have agreed to arbitration procedures which are set out in a memorandum of understanding (effective November 12 2010).(2) As shown in the figure below, specific time limits apply to each stage in the arbitration process, subject to limited exceptions. For example, if required information is missing, the tax authorities can delay the commencement of arbitration.

Figure 1

Mandatory arbitration under the Canada-US Income Tax Convention is conducted 'baseball style' – that is, for each separate issue under dispute, the arbitration panel must select one of the two countries' positions (rather than creating a compromise solution). Since the panel provides no rationale or analysis for its decision, the decision has no precedential value (ie, it applies only to the specific tax issue and taxation year(s)). The three-person arbitration panel is assembled by having each country appoint one person, with those two appointees then selecting (by consensus) the third person to act as the panel chair. The panel's determination (by majority vote) generally must be made within six months of the chair's appointment and is binding on both countries. The concerned taxpayer must accept the determination within 30 calendar days of receiving it, or the taxpayer is considered to have rejected it and the tax authorities can proceed with their reassessments. The arbitration may be terminated before the panel's decision if the concerned taxpayer so requests, or if the countries' tax authorities agree on a settlement. Special rules, procedures and timelines may apply in arbitrations involving advance pricing agreements, permanent establishment issues or accelerated requests, or where multiple tax issues are under dispute.

For taxpayers, the chief advantages of pursuing the mutual agreement procedure and mandatory arbitration procedure under the Canada-US Income Tax Convention over the CRA's domestic appeals process are:

  • obtaining tax certainty for transfer pricing issues in both treaty countries simultaneously;
  • reducing or eliminating double taxation; and
  • potentially incurring lower costs as compared to litigation.

On the downside, the taxpayer is not involved in the mutual agreement procedure negotiations (whereas it would participate in the CRA appeals process), and generally the taxpayer's only option is to accept or reject a mutual agreement procedure settlement or mandatory arbitration decision. However, there is flexibility in the process, since taxpayers can still pursue the CRA's appeals process if they decide to reject the mutual agreement procedure settlement or mandatory arbitration decision under the Canada-US Income Tax Convention.

Overall, the mandatory arbitration provision may help Canadian taxpayers involved in double tax disputes with the United States by reducing the time it takes for resolving those disputes, as well as by motivating Canadian and US tax authorities to reach a compromise before arbitration becomes necessary. It may also encourage them to be more careful when evaluating the strength of their positions and the reasonableness of their proposed reassessments (since they risk being overturned by a mandatory arbitration panel).

For further information on this topic please contact Salvatore Mirandola, Patrick Lindsay or Stephanie Wong at Borden Ladner Gervais LLP by telephone (+1 416 367 6000), fax (+1 416 361 7090) or email ([email protected], [email protected] or [email protected]).


(1) See CRA transfer pricing memorandum TP-05, contemporaneous documentation, available at

(2) See the CRA's website at