Transfer pricing rules in Canada

Introduction to Transfer Pricing

Generally, inter-company transactions across different tax jurisdictions are subject to complex global tax compliances, one of which is Transfer Pricing “TP”. When two or more Associated Enterprises transact with each other, the “price” at which the transaction is valued is called Transfer Price. The whole idea of TP is based on a question that whether the price at which international transaction has been entered is at arm’s length price or not.

ALP (ALP)

What Is Arm’s Length Principle?

Based on the TP rules, when two related parties enter into a commercial transaction, the price should be the same as if the two companies were independent of each other, also known as “Arm’s Length Principle”. In simple words, it is the price at which unrelated parties transact with each other in an independent market condition. This principle gives basis of terms and conditions that would be akin, whether the entity enters into a transaction with its group companies or with unrelated parties.

Rules of Canadian TP will be applicable if:

Determination of ALP

The Canadian statutory rules on TP mentioned in section 247 of Canada’s Income Tax Act (“ITA” or “the Act”) are effective for taxation periods beginning after 1997. The legislation is supported by Canada Revenue Agency “CRA’s” information circular 87-2R (IC 87-2R) and TP memoranda (TPM-02 through TPM-17). CRA has stated that IC 87-2R has been cancelled effective 30 December 2019, since it was inconsistent with the latest interpretations of the Act’s TP regulations. Also, the intention behind this was to give priority to Canadian TP rules in section 247 of the Act. CRA’s current view is available in TPM-14 2010 update of OECD guidelines which is consistent with the cancelled 87-2R. It shows the believe of CRA that selection of method must be done keeping in mind the “degree of comparability analysis” and “availability and reliability of the data”, under each method.

The CRA accepted the TP methods provided in “Organization for Economic Co-operation and Development” (“OECD”) TP guidelines such as comparable uncontrolled price, resale price, cost plus, transactional net margin, and profit split methods. Further,” other method” can also be used if appropriate. According to CRA beliefs traditional transaction methods are preferable over transactional profit methods.

According to section 247(4) of the Act:

• any person or partnership firm entering into a international transaction in nature of purchase, sale, provision of services, receipt of services, cost-contribution arrangements, transfer of intangible property and intragroup services;
• with its related party which participates, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise;
• or in respect of which one or more persons who partici¬pate, directly or indirectly, or through one or more intermedi¬aries, in its management or control or capital, are the same persons who participate, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise;
• are required to prepare a contemporaneous documentation showing the transaction at the arm’s length price.

Here, section 247(4) of ITA requires documentation for the purpose of TP in Canada. Although, taxpayers is not required to prepare Master File or Local File, as been suggested in OECD TP Guidelines.

The documentation should cover all material aspects mentioned in section 247 (4)(a)(i) to 247 (4)(a)(vi), and should be prepared by tax return filing date. The documentation should be submitted, within 3 months of written request made by a CRA.

To make TP documentation stronger and more robust, it should include inter-company agreements, copies of invoices and payments, details of any intangibles and any fee paid for the use of such intangibles, details of any cross-charges or management fees, selection of most appropriate method, industry and economic analysis and any adjustments done by the taxpayer to conform to the arm’s length prices.

Section 247, is not applicable on transactions happening between persons within Canada who are not at arm length i.e., domestic transactions. So in those cases there are no such requirements pertaining to preparation of TPD.

New Reporting Requirements for large MNEs

As been suggested in base erosion and profit shifting “BEPS” action plan 13, the ITA now incorporates country-by-country reporting CbCR. Any MNE group with total consolidated group revenue of €750 million or more in the immediately preceding fiscal year, as represented in its consolidated financial statements, is subject to CbCR reporting obligations and have to file Form RC 4649.

The CbCR report must be filed by:

• Ultimate Parent entity “UPE” of MNE, when UPE is based in Canada throughout the reporting fiscal year, or
• by the Constituent Entity (CE) of MNE (subject to certain conditions).

The guidance to CbCR by CRA is given in the Form RC 4649 to determine if it applies to the person. Further the Guide RC 4651 helps the person in completing the report and it is supported by section 233.8 of the ITA. The due date for filing CbCR is within 12 months after the last date of the “Reporting Fiscal Year” of the MNE Group.

Risk factors that are considered for Scrutiny

Risk assessment procedure, applies to Transfer Price Audit as well. Generally, selection of target taxpayers approach depends upon the risk of non-compliance i.e., high risk taxpayers. It can be applied on any entity irrespective of its form or nature of industry. Some of such factors which determine taxpayers with high risk of non-compliance, is given below:

• Maintenance of Contemporaneous documentation as per section 247(4)
• Transactions with low tax jurisdictions
• History of non-compliance
• Transactions involving corporate restructurings
• Know how transactions
• Intra group services, royalty-based transaction
• High transaction materiality in form T106
• Ongoing losses or low profits in Canada, etc.

to CRA to make adjustment in prices in cross border transactions (between the AEs) which are not at ALP. While making such adjustment, CRA can apply penalty for non- compliance with TP documentation requirements. Although, if reasonable efforts are made by the taxpayer for making a TP Document, then penalty cannot be imposed by CRA. To understand what reasonable effort means, one can refer to TPM-09 in which CRA’s administrative approach on reasonable efforts is provided.

TPM-13 on referrals to the TP review committee can also be referred to understand CRA’s contention to recharacterize transactions in certain situations.

Below is summary table on Penalties.

Foreign Reporting Obligations (Forms)

Information returns of non-arm’s length transaction with non-residents-Form T106

Persons conducting business in Canada must file an annual information return detailing transactions entered into with AE, to Canada Revenue Agency. As required by Form T106, we also need to state business activities of reporting partnership/person by entering appropriate North American Industrial Classification System (NACIS) Codes.

A separate Form T106 is required to be reported by taxpayer for each AE, provided that the market value of transactions reportable with all related non-resident exceed threshold of 1 million CAD.

Information returns related to controlled and non-controlled foreign affiliates-Form T1134

• A taxpayer resident in Canada (excluding taxpayer whose taxable income is exempt from income tax under Part 1 of the act)
  • who has a non-resident corporation or trust acting as a Foreign affiliate (FA) / Controlled Foreign Affiliate (CFA) at any time during the year.

• A partnership where:
  • The share of profits/loss of the non-residents < 90% of the profit/loss of the partnership; and
  • If the partner is a resident in Canada. A NR Corp. or trust was FA or CFA of the partnership at any time during the year

Above mentioned taxpayers are required to file form T1134 with in respective deadline according to taxpayer’s income tax return deadlines. Different penalties can be attracted towards non-compliance of Form T1134.

Statutory Rules

• Canadian Guidelines - Canadian Revenue Agency provides TP guidelines and legislation.
  • Section 247, Income Tax Act
  • TP Memoranda (from TPM 02 to TPM 17)
  • Tax treaties
  • Permanent Establishment guidelines
• For Economic analysis and to exhibit arm’s length outcome, certain specific interpretations and administrative positions of CRA are shown in the TPMs such as:
  • TPM-06 – Bundled Transactions
  • TPM-09 – Reasonable efforts under section 247 of the Income Tax Act
  • TPM-14 – 2010 Update of the OECD TP Guidelines
  • TPM-15 – Intra-group services and section 247 of the Income Tax Act
  • TPM-16 – Role of Multiple Year Data in TP Analyses
  • TPM-17 – The Impact of Government Assistance on TP
• OECD Guidelines
  • Canada is a member of the OECD. The Canadian TP legislation was redrafted in 1997 to conform with the OECD Guidelines.
  • OECD Guidelines are one among most important Responsible Business Conduct (RBC) Guideline.
  • OECD Model Convention and the OECD TP Guidelines for Multinational Enterprises and Tax Administrations are highly admired though no reference is made in Section 247 of ITA.
  • Associated publications have been cited in a number of Canadian TP court cases, they are not explicitly recognized as authoritative by the courts.
• Others
  • While it's recognized that some developing country Inclusive Framework members can also follow the United Nations Practical Manual on TP for Developing Countries (2017), this Guidance should be helpful in such circumstances where the UN Manual follows an identical analytical framework and allows for similar conclusions because the OECD TP Guidelines.

Conclusion

• CRA has provided TP guidance and its administrative positions on issues through TP memoranda and information circulars such as IC87-2R (now cancelled), IC 71-17R5 on competent authority assistance which is under revision.
• The views available in TPM and ICs are suggestive and not mandatory.
• Canadian courts may directly refer statutory provisions rather than published material by CRA.