Since 2012, there have been unprecedented developments in Canada and globally in the area of international tax. The sheer volume and complexity of these developments make it difficult for Canadian corporations to keep up on what changes actually impact transfer pricing. Also during this period, in addition to some developments in the area of self-initiated transfer pricing adjustments, Canada generated several high profile court cases related to transfer pricing. This article, which will be released in three parts, provides an update on what is new in the Canadian transfer pricing landscape since 2012 when the Organisation for Economic Co-operation and Development ("OECD") began its Base Erosion and Profit Shifting ("BEPS") project. Part I provides a general overview of the transfer pricing developments in Canada during this period. Parts II and III, which will follow, will provide a brief summary of Canadian transfer pricing cases during this period and recent developments in the area of self-initiated transfer pricing adjustments.
Revised Transfer Pricing Guidelines
The BEPS project was an enormous global undertaking which addressed a number of concerns relating to international corporate tax planning. However, the most significant and immediate impact of the BEPS project was on transfer pricing. More specifically, Actions 8 to 10 of the BEPS project addressed several areas of transfer pricing related to the arm's length principle and introduced significant revised guidance in the form of amendments to the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations ("Transfer Pricing Guidelines"). These amendments were added to the Transfer Pricing Guidelines in 2017 and have been fully endorsed by the Government of Canada. For example, the Government of Canada stated in Budget 2016 that "the clarifications provided in the revisions generally support the [CRA]'s current interpretation and application of the arm's length principle".
In brief, the BEPS project, as it pertained to transfer pricing, attempts to prevent aggressive profit shifting strategies by amending the Transfer Pricing Guidelines to better align the arm's length principle and transfer pricing outcomes with value creation. This was accomplished by placing more emphasis on the allocation of profits to the jurisdiction where substantive functions are performed, including the control functions related to risks assumed and capital employed. Legal ownership of assets and contractual assignment of risk play a reduced role, compared to the weight that used to be given to those factors. The reform in the Transfer Pricing Guidelines has had a significant impact on transfer pricing planning, especially in intellectual property migration strategies.
For a detailed discussion on the impact of the revised Transfer Pricing Guidelines, please refer to our previous article entitled IP Migration Strategies: Pre and post - BEPS.
Country-by Country Reporting
In 2015, the OECD's final report on BEPS Action 13 recommended that countries adopt a standardised approach to transfer pricing documentation. The objective was to provide tax administrations with better information for conducting risk assessments of transfer pricing situations. The final report recommended a three-tiered structure consisting of i) a master file containing standardised information relevant for all multinational enterprise ("MNE") group members, ii) a local file referring specifically to material transactions of the local taxpayer and iii) a country-by-country ("CbC") report containing certain information relating to the global allocation of the MNE's income and taxes paid together with certain indicators of the location of economic activity within the MNE group. Shortly after the Government of Canada introduced new section 233.8 of the Income Tax Act ("Act") to require CbC reporting. The requirements of new section 233.8 were consistent with the final recommendations made by the OECD with respect to CbC reporting. On February 3, 2017, the CRA released new Form RC4649, Country-by-Country Report, for fiscal years that begin after 2015. Form RC4649 is the prescribed form reporting entities must use, in accordance with the CbC reporting requirements under section 233.8, to report the allocation of income, taxes and business activities of a MNE by tax jurisdiction.
For a detailed discussion on CbC reporting, please refer to our previous article entitled Changes Coming to Country-by-Country Transfer Pricing Documentation Requirements.
Multilateral Convention to Implement the Tax Treaty Measures to Prevent BEPS ("MLI")
In June, 2017, Canada signed the MLI whereby it agreed to modify its bilateral tax treaties to implement BEPS treaty reforms. On June 21, 2019, Bill C-82, An Act to implement a multilateral convention to implement tax treaty related measures to prevent base erosion and profit shifting, received Royal Assent and became law. It is anticipated that Canada will notify the OECD through the deposit of its instruments of ratification before the end of 2019. If so, the MLI will then enter into force for Canada on the first day of the month following the expiration of a three month period from the date of notice to the OECD.
The MLI is a significant achievement within the international tax community to ensure the timely implementation of certain key minimum standards, as well as other optional recommendations, arising from the OECD BEPS project. The three minimum standards are (i) a broad anti-avoidance treaty shopping rule (i.e. the principal purpose test), (ii) an amended preamble indicating that Covered Tax Treaties are intended to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance and (iii) modified dispute resolution procedures which include the adoption of mandatory arbitration procedures. It is this third minimum standard that may ultimately have a slight impact on transfer pricing.
It is often taxpayers with transfer pricing disputes who are the main benefactors of a mandatory arbitration provision in a treaty. For example, under the Mutual Agreement Procedure ("MAP") where transfer pricing cases are involved, there can be lengthy delays in competent authorities reaching MAP settlements due to the complexity of the cases and the significant dollar amounts at dispute. Also, in complex transfer pricing cases, on occasion the competent authorities cannot reach a MAP settlement that fully resolves double taxation. So, the introduction of mandatory arbitration in more of Canada's tax treaties is a good development in the transfer pricing world. The 5th Protocol to the Canada – United States Tax Convention ("Canada-U.S. Treaty") already introduced binding arbitration and that has proven to be a success in motivating the Canadian and U.S. competent authorities to achieve more timely MAP settlements on transfer pricing cases.
For a detailed discussion on the MLI, please refer to our previous article entitled Hot Off the Presses: Canada Signs the Multilateral Instrument.
Canadian Competent Authority
There is not much new to report regarding the CRA's Competent Authority Services Division ("CASD") and its MAP and Advance Pricing Arrangement ("APA") programs. Other than a steady stream of personnel changes since 2012, the corporate structure and administrative process has not changed. Although CASD has indicated that they are working on a much needed update to Information Circular 71-17R5 Guidance on Competent Authority Assistance Under Canada's Tax Conventions, which was last updated on January 1, 2005, there is still no news as to when the tax community can expect it.
Based on CASD's annual MAP reports, it would appear that its transfer pricing MAP inventory is gradually declining. Although CASD's MAP inventory will always be impacted by the current level of CRA audit activity, which can go through trends and cycles, several other factors may contribute to this decline in inventory, including i) CASD is more efficient in closing MAP files as a consequence of the arbitration deadline in the Canada - U.S. Treaty, ii) most of Canada's larger corporations have been audited on multiple occasions over the last few decades and many of the core issues within their transfer pricing disputes have been resolved or are the subject of routine APA renewals and iii) more files are being dealt with by CRA Appeals and the Courts. The latter factor has become a trend in recent years, particularly in those transfer pricing cases where resolution of double taxation is not the primary objective in choosing the dispute resolution process (e.g. foreign corporation resides in a non-treaty country or a low tax treaty country or the foreign company has significant losses – see for example the Marzen and Cameco decisions to be discussed in Part II of the series).
Another trend is that APA requests are receiving much closer scrutiny by CASD before officially being accepted into the APA program. The main stumbling block seems to be where the Canadian taxpayer has, at the outset, a significantly different transfer pricing methodology, or arm's length price outcome, than CASD's preliminary views. So, rather than CASD setting itself up for an adversarial bilateral negotiation with its foreign counterpart, they simply deny the taxpayer access into its APA program. In other words, CASD would rather have the CRA audit the taxpayer and then deal with it in its MAP program with the additional support of a detailed audit report.
When a transfer pricing adjustment is made, the CRA has determined that the arm's length transfer price in respect of a transaction between non-arm's length parties is different from the transfer price the parties originally chose for themselves and reported for tax purposes. The adjustment, usually referred to as the primary adjustment, is made pursuant to subsection 247(2) and is generally an adjustment to the Canadian resident taxpayer's understated revenues or overstated expenses. A secondary adjustment addresses the Part XIII withholding tax issues with respect to the cross-border flow of funds resulting from use of the non-arm's length portion of the initial transfer price. For example, if a Canadian subsidiary pays more than the arm's length price to a foreign parent for the provision of services, the amount of the adjustment is a benefit, or overpayment, to the foreign parent that should be subject to Part XIII withholding tax.
Prior to March 30, 2012, secondary adjustments were raised using traditional benefit conferral provisions in the Act. Effective for transfer pricing transactions after March 29, 2012, the Department of Finance introduced new deemed dividend and repatriation rules for secondary adjustment by adding subsections 247(12) to (15). The application of traditional benefit conferral rules was often problematic for the CRA, particularly where the cross-border transaction did not involve a direct parent/subsidiary transaction. Also, prior to the new rules all CRA repatriation policies were purely administrative. There were also inconsistent policies between CRA divisions on the repatriation policy (e.g. CASD repatriation policy versus Audit's repatriation policy). Although the new rules were needed, much uncertainty remains regarding the application of these rules and the CRA repatriation policies. We understand that the CRA have been working on new guidelines, in light of the 2012 legislative amendments and other problems, but there have been no announcements as to when such guidelines will be published.
Important CRA Technical Interpretations Impacting Transfer Pricing
CRA's advanced income tax rulings and technical interpretations very seldom deal with transfer pricing matters. This is mainly because the CRA's Income Tax Rulings Directorate ("ITRD") does not give rulings on either domestic or cross-border valuation matters. In the context of transfer pricing, it is CASD that provides those services under its APA program. However, on occasion, technical interpretations or advance tax rulings with respect to interpretive issues within section 247 are dealt with by the ITRD. In the last few years, the ITRD have issued a couple of transfer pricing related technical interpretations ("TI") of particular interest.
In TI 2016-0631631I7, the CRA concluded that it can make a transfer pricing adjustment under subsection 247(2) at any time, even though the relevant transaction and the relevant amount arose in a year that is statute-barred for reassessment of tax under subsection 152(4). This adjustment can then be used to reassess tax in an open year. The example given was a transfer pricing adjustment to the adjusted cost base ("ACB") of property acquired in a statute-barred year. The reduced ACB could then be used to reassess tax on a higher capital gain realized in the open year. Furthermore, the CRA said that although tax cannot be reassessed for a statute-barred year, the 10% transfer pricing penalty under subsection 247(3) can apply. In other words, in the CRA's view, an initial 10% transfer pricing penalty can be imposed at any time under subsection 247(3). In the example considered, the reduction to the ACB of the property acquired in the statute-barred year would be a transfer pricing capital adjustment ("TPCA") in that statute-barred year. This TPCA would then be relevant for purposes of potentially imposing the 10% transfer pricing penalty for that statute-barred year under subsection 247(3).
In TI 2017-0694231I7, the CRA concluded that where a transfer pricing adjustment is made to a corporation resident in Canada with respect to a transaction with its wholly owned controlled foreign affiliate ("CFA") which impacts the CFA's surplus or foreign accrual property income ("FAPI"), the CRA cannot reduce the surplus or FAPI. This is good news in the context of certain exempt surplus pot calculations, but bad news in the context of a FAPI situation as it results in double tax. The technical interpretation letter does not discuss whether CRA considered the possible application of subsection 248(28) as a means of avoiding double tax.
Budget 2019 – New Transfer Pricing Ordering Rule
In some transfer pricing cases, both the transfer pricing rules and other provisions of the Act can apply to the same amount, creating uncertainty as to which provision should be given priority, e.g., when determining the relevant amount for the computation of tax. The interaction of subsection 247(2) with other provisions in the Act is complex and full of ambiguity. Further confusion arises as a consequence of the CRA's comments in paragraphs 20 to 24 of its Information Circular 87-2R International Transfer Pricing, which suggests that certain sections of the Act should be applied before considering the more general provisions of section 247. This statement in the Circular is, arguably, inconsistent with certain statements made by the CRA at the 2017 IFA conference regarding the interaction of subsections 17(1) and 247(2). Budget 2019 proposed to amend the Act to clarify that the transfer pricing rules in Part XVI.1 must be applied before any other provision of the Act, including income computation provisions in Part I. Although the intention of the Department of Finance was to attempt to resolve ambiguity as to ordering of the respective operations of Parts I and XVI.1, the proposal has raised some concerns in the tax community. At the IFA conference on May 15, 2019, the Department of Finance indicated that, in light of the feedback received from the tax community, it will look further into the matter before proceeding with any legislative amendments.