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Canada, like the United States and other countries that follow the Organization for Economic Cooperation and Development (OECD) guidelines, bases its approach to transfer pricing, i.e. the tax treatment of cross-border transactions between related parties, on the arms-length principle. In this issue of the Tax Insight newsletter, we provide an overview of transfer pricing guidelines in Canada, and explain some of the key similarities/differences to the U.S. transfer pricing rules.
The following is an overview of the major provisions of Canada's transfer pricing policies:
Subsection 247(3) imposes a penalty in instances where the taxpayer fails to make reasonable efforts to determine and use arms-length transfer prices. The penalty is calculated as 10 percent of the taxpayer's reduced, unfavorable transfer pricing adjustments if they exceed the lesser of $5 million (Canadian dollars) or 10 percent of the taxpayer's gross revenue. Conversely, in the United States the penalty is a percentage of the actual tax paid.
Subsection 247(4) of the Income Tax Act imposes a set of documentation requirements which must be met for the taxpayer to be deemed to have made reasonable efforts to determine and use arms-length transfer prices or allocations. The taxpayer must prepare or obtain the required documentation within six months from the end of its tax year. Upon request from the CRA, the taxpayer must present the required documentation within three months after receipt of a written request to do so. Failure to present the documentation on time will result in the taxpayer being deemed to have failed to make reasonable efforts.
The taxpayer must also file an annual return, Form T106, Information Return of Non-Arms Length Transactions with Non-Residents, which requires the filer to attest that contemporaneous documentation exists by checking a box on the form. It is important to note that if the taxpayer doesn't have the documentation but has checked the box it could be construed as fraud. While the U.S. has a similar form (5471), the form does not include a box to verify documentation.
Like the U.S., the CRA has an Advance Pricing Agreement (APA) program to help taxpayers determine appropriate transfer pricing methods. The process of obtaining an APA is laid out in IC 94-4R. The term of an APA is usually three to five years, but may vary depending on the facts, circumstances, and resolution of the particular case. The taxpayer must file APA reports according to the terms of its APA. An APA report will describe the taxpayer's actual operations for the period and demonstrate its compliance with the terms and conditions of its APA.
In a recent court case involving GlaxoSmithKline, Inc., the Tax Court of Canada considered the question of whether or not it should analyze both the purchase price paid under the supply agreement and the royalty paid under the licensing agreement together, or instead analyze each agreement separately. The case centered around the proper transfer price of a key ingredient in one of its drugs.
Glaxo's position was that the supply and licensing agreements were inseparable, and the company's concern was for the total net transfer price. The CRA argued that each element of the transaction was distinct and warranted distinct tax consideration.
The Court sided with the CRA and determined that the reasonableness of each agreement must be analyzed separately. As a result of this determination, the Court held that with respect to the supply agreement, generic drug transactions constituted appropriate comparables. The case has been interpreted as an indication that Canada strictly applies the hierarchy of methods provided by the OECD guidelines, and that it strongly prefers the comparable uncontrolled price method and other transaction methods over profit-split methods.
To summarize, Canada closely follows the OECD Guidelines, and has structured its statutory law, case law, and administrative guidance around the idea that Canada's law is essentially an application of the Guidelines. In addition, Canada and the U.S. are consistent on the following issues:
VRC has extensive experience assisting clients with transfer pricing engagements. For more information contact your VRC representative.