An extract from The Transfer Pricing Law Review, 5th Edition
Canada has a long history of transfer pricing rules in its income tax laws. The current iteration of transfer pricing rules can be found in Section 247 of the Income Tax Act (the Act). This rule applies to any Canadian resident taxpayer of any kind who transacts with a non-resident of Canada with whom it does not deal at arm's length for purposes of the Act.
The concept of arm's length in the Act is defined to include all related parties (generally those where one is directly or indirectly legally controlled by the other, or where they are under common legal control) as well as those who are, as a matter of fact, not dealing at arm's length. This concept of factual non-arm's-length relationship can be uncertain at times but has been interpreted by the courts to include:
- where there is a common mind directing the bargaining for both parties;
- where parties are acting in concert without separate interests; and
- where one party has exercised de facto control over the other.2
Subsection 247(2) of the Act contains two separate substantive rules:
- a 'regular' transfer pricing rule that permits the Minister of National Revenue (in practice, the Canada Revenue Agency or CRA) to adjust a taxpayer's tax results to those that would have resulted had the 'terms and conditions' of transactions between parties not dealing at arm's length been those terms and conditions that would have been made or agreed to parties dealing at arm's length, and
- a 'recharacterisation rule' permitting CRA to recharacterise a transaction and determine tax results based on such hypothetical transaction that would have been undertaken by arm's-length parties, implemented on arm's-length terms and conditions, which rule is available where a transaction or series of transactions would not have been undertaken by parties dealing at arm's length and such transaction or series can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit.
The Act specifically excludes from the application of Section 247 loans to, or guarantee fees in respect of the guarantee of the debts of, a 'controlled foreign affiliate' of a taxpayer. Shareholder transactions, such as dividends, returns of capital, and contributions of capital (outside the context of a cost contribution arrangement), are generally not subject to the transfer pricing rules in Section 247.
Section 247 of the Act was first enacted in 1998 with the express intent of aligning Canada's transfer pricing rules more closely with the international 'arm's-length' standard as expressed in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines). Canada also has an extensive treaty network, with 94 double tax treaties currently in force. These treaties are mostly based on the OECD Model Tax Convention on Income and Capital, including the Article 9 transfer pricing provisions, which themselves tie into the arm's-length principle as set out in the OECD Guidelines.
When reference is made to the OECD Guidelines, courts have not been entirely consistent regarding which version should be consulted. By analogy to case law3 dealing with reliance on the Commentary on the OECD Model Tax Convention on Income and Capital in the interpretation of tax treaties, recourse to a variety of versions of the OECD Guidelines may be justified. However, it is arguable that new concepts introduced into the OECD Guidelines after a particular transaction was entered into should not be relied upon to evaluate the arm's-length pricing of such transaction.
Notwithstanding this connection to the OECD Guidelines, Section 247 does not reference those guidelines or in any other way incorporate them into Canadian law. The result is a uniquely Canadian rule, albeit one whose application continues to be strongly influenced by the OECD Guidelines. Many of the decided court cases on transfer pricing in Canada make reference to the OECD Guidelines, but the Supreme Court of Canada has made it clear that:
[T]he Guidelines are not controlling as if they were a Canadian statute and the test of any set of transactions or prices ultimately must be determined according to s. 69(2)4 rather than any particular methodology or commentary set out in the Guidelines.5
Rulings such as this, and others that have followed, continue to make it difficult for CRA to rely on some of the approaches or theories in the OECD Guidelines that rely on preferring alleged 'economic substance' over the substance of the legal relationships governing a taxpayer's transactions. Both CRA and the Department of Finance have stated that these decisions, including the restrictions placed on the applications of the recharacterisation rule, highlight 'shortcomings' in Canada's transfer pricing laws. The 2021 Canadian federal budget, released on 19 April 2021, announced that the government intends to release a consultation paper in the coming months setting out possible changes to improve Canada's transfer pricing rules. These proposals are not yet available; taxpayers and advisors alike are anxious to see what new directions may be proposed for Canada's transfer pricing rules.
Broader taxation issuesi Diverted profits tax, digital sales taxes and other supplementary measures
Canada has not considered the adoption of a diverted profits tax.
Canada has expressed a desire to address the challenges of the digital economy through multilateral initiatives, including in particular the OECD/Inclusive Framework work on Pillar One and Pillar Two. However, the government of Canada has grown impatient. Following on similar measures in other countries, the government reiterated in the 2021 Canadian federal budget its intention to introduce a new gross-revenue based Digital Services Tax (DST). The proposed DST will be imposed at a rate of 3 per cent on revenues from digital services that rely on data and content contributions from Canadian users. The DST would apply only to taxpayers meeting both the following thresholds (alone or together with group members):
- global revenue from all sources of €750 million or more in the previous calendar year, and
- in-scope revenue associated with Canadian users of more than C$20 million in the particular calendar year.
The DST is stated to take effect on 1 January 2022, while being specifically stated to be a temporary measure that is intended to be replaced by the agreed multilateral approach once that can be implemented. In an interesting move, likely designed to insulate the DST from potential claims for relief under an applicable tax treaty, the DST will not be implemented under the Tax Act, but instead under a separate statute. Under normal principles, the DST should usually be deductible, but it would not qualify for a credit against Canadian income tax otherwise payable.ii Tax challenges arising from digitalisation
As noted above, the government of Canada remains committed to a multilateral approach to these issues, notwithstanding the introduction of the proposed DST as an interim measure. Specific details regarding the government of Canada's view on how the proposed Pillar One and Pillar Two concepts would be implemented are not available at this time.iii Transfer pricing implications of covid-19
Canada provided some limited guidance and relief 23 in response to the covid-19 pandemic in respect of certain international tax issues, including, in particular, cross-border employment and the issues of residence, permanent establishment, and carrying on business in Canada. Canada has neither provided any indication of its views of the transfer pricing implications of covid-19, nor has it specifically adopted the OECD's guidance in this regard.iv Double taxation
Canada has an extensive treaty network, and a very experienced Competent Authority Services Division (CASD) within CRA. Applications to CASD for relief from double taxation under the mutual agreement procedure (MAP) provisions of Canada's tax treaties can be made following the issuance of a notice of assessment or reassessment. Canada's treaties are not consistent in terms of the limitation periods and notice requirements applicable to MAP cases, and so each treaty should be carefully consulted.
MAP relief is most often sought in advance of recourse to the domestic appeals process, with that domestic appeals process being held in abeyance pending the possible resolution of the issue by the competent authorities. It is also possible to seek MAP relief after initially engaging with the domestic CRA Appeals group.
Only a few of Canada's existing treaties contemplate mandatory arbitration, most notably the treaties with the United States of America, the United Kingdom and Switzerland. Of these, there is some history of successful resolutions being achieved under the arbitration provisions of the Canada-US treaty, though the results of each case are confidential. Canada has notified that it generally is prepared for the arbitration provisions of the OECD's Multilateral Instrument (MLI) to apply to its covered agreements, with the 'final offer' process being the default, subject to agreement and negotiation with each applicable counterparty.
While Canada will always 'present' a case to the competent authority of another jurisdiction for relief when properly requested, it is CRA's policy to not negotiate any settlement in cases where certain anti-avoidance rules have been applied, including, in particular, the general anti-avoidance rule and the transfer pricing recharacterisation rule. As noted above, the application of the proposed DST may give rise to double tax that will not be eligible for MAP relief.
CASD is also active in negotiating bilateral APAs with Canada's treaty partners, and may also consider unilateral APAs in some circumstances.
Outlook and conclusions
Transfer pricing remains an area of particular focus for CRA, with many additional resources being specifically allocated by the government to the enforcement of 'international' tax rules in recent years. Taxpayers can expect this to be an area of continued audit focus and activity.
We can also expect to deal with many new developments in this area, in particular the implications of the proposed DST and any multilateral approach to the digital economy that is ultimately implemented, as well as the consultation paper, expected to be released in the summer or autumn of 2021, seeking input on yet-to-be-proposed changes to reform Canada's transfer pricing rules to address the shortcomings (perceived by the government, especially following recent case law) of these rules.