Overview Legislative Requirements S. 247 The Role of the Transfer Pricing Review Committee Practical Ways to Avoid Penalties Questions for the CRA

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1 February 13, 2012 Andrew McCrodan, PricewaterhouseCoopers LLP Jennifer Ryan, Paul Stesco, Canada Revenue Agency Chair: Brandon Siegal, McCarthy Tétrault LLP Overview Legislative Requirements S. 247 The Role of the Transfer Pricing Review Committee Practical Ways to Avoid Penalties Questions for the CRA 2

2 Legislative Requirements S. 247 Transfer pricing adjustment (2) Where a taxpayer or a partnership and a non-resident person with whom the taxpayer or the partnership, or a member of the partnership, does not deal at arm s length (or a partnership of which the non-resident person is a member) are participants in a transaction or a series of transactions and (a) the terms or conditions made or imposed, in respect of the transaction or series, between any of the participants in the transaction or series differ from those that would have been made between persons dealing at arm s length, or (b) the transaction or series (i) would not have been entered into between persons dealing at arm s length, and (ii) can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit, any amounts that, but for this section and section 245, would be determined for the purposes of this Act in respect of the taxpayer or the partnership for a taxation year or fiscal period shall be adjusted (in this section referred to as an adjustment ) to the quantum or nature of the amounts that would have been determined if, (c) where only paragraph 247(2)(a) applies, the terms and conditions made or imposed, in respect of the transaction or series, between the participants in the transaction or series had been those that would have been made between persons dealing at arm s length, or (d) where paragraph 247(2)(b) applies, the transaction or series entered into between the participants had been the transaction or series that would have been entered into between persons dealing at arm s length, under terms and conditions that would have been made between persons dealing at arm s length. 3 Legislative Requirements S. 247 Penalty (3) A taxpayer (other than a taxpayer all of whose taxable income for the year is exempt from tax under Part I) is liable to a penalty for a taxation year equal to 10% of the amount determined under paragraph 247(3)(a) in respect of the taxpayer for the year, where (a) the amount, if any, by which (i) the total of (A) the taxpayer s transfer pricing capital adjustment for the year, and (B) the taxpayer s transfer pricing income adjustment for the year exceeds the total of (ii) the total of all amounts each of which is the portion of the taxpayer s transfer pricing capital adjustment or transfer pricing income adjustment for the year that can reasonably be considered to relate to a particular transaction, where (A) the transaction is a qualifying cost contribution arrangement in which the taxpayer or a partnership of which the taxpayer is a member is a participant, or (B) in any other case, the taxpayer or a partnership of which the taxpayer is a member made reasonable efforts to determine arm s length transfer prices or arm s length allocations in respect of the transaction, and to use those prices or allocations for the purposes of this Act, and is greater than (b) the lesser of (i) 10% of the amount that would be the taxpayer s gross revenue for the year if this Act were read without reference to subsection 247(2), subsections 69(1) and 69(1.2) and section 245, and (ii) $5,000,000. 4

3 Legislative Requirements S. 247 Contemporaneous documentation (4) For the purposes of subsection 247(3) and the definition qualifying cost contribution arrangement in subsection 247(1), a taxpayer or a partnership is deemed not to have made reasonable efforts to determine and use arm s length transfer prices or arm s length allocations in respect of a transaction or not to have participated in a transaction that is a qualifying cost contribution arrangement, unless the taxpayer or the partnership, as the case may be, (a) makes or obtains, on or before the taxpayer s or partnership s documentation-due date for the taxation year or fiscal period, as the case may be, in which the transaction is entered into, records or documents that provide a description that is complete and accurate in all material respects of (i) the property or services to which the transaction relates, (ii) the terms and conditions of the transaction and their relationship, if any, to the terms and conditions of each other transaction entered into between the participants in the transaction, (iii) the identity of the participants in the transaction and their relationship to each other at the time the transaction was entered into, (iv) the functions performed, the property used or contributed and the risks assumed, in respect of the transaction, by the participants in the transaction, (v) the data and methods considered and the analysis performed to determine the transfer prices or the allocations of profits or losses or contributions to costs, as the case may be, in respect of the transaction, and (vi) the assumptions, strategies and policies, if any, that influenced the determination of the transfer prices or the allocations of profits or losses or contributions to costs, as the case may be, in respect of the transaction; 5 Legislative Requirements S. 247 Contemporaneous documentation (4) cont (b) for each subsequent taxation year or fiscal period, if any, in which the transaction continues, makes or obtains, on or before the taxpayer s or partnership s documentation-due date for that year or period, as the case may be, records or documents that completely and accurately describe each material change in the year or period to the matters referred to in any of subparagraphs 247(4)(a)(i) to 247(4)(a)(vi) in respect of the transaction; and (c) provides the records or documents described in paragraphs 247(4)(a) and 247(4)(b) to the Minister within 3 months after service, made personally or by registered or certified mail, of a written request therefore. 6

4 Legislative Requirements S. 247 Deemed dividends to non-residents (12) For the purposes of Part XIII, if a particular corporation that is a resident of Canada for the purposes of Part XIII would have a transfer pricing capital adjustment or a transfer pricing income adjustment for a taxation year, if the particular corporation, or a partnership of which the particular corporation is a member, had undertaken no transactions or series of transactions other than those in which a particular non-resident person, or a partnership of which the particular non-resident person is a member, that does not deal at arm s length with the particular corporation (other than a corporation that was for the purposes of section 17 a controlled foreign affiliate of the particular corporation throughout the period during which the transaction or series of transactions occurred) was a participant, (a) a dividend is deemed to have been paid by the particular corporation and received by the particular non-resident person immediately before the end of the taxation year; and Non-application of provisions (15) Section 15, subsections 56(2) and 212.3(2) and section 246 do not apply in respect of an amount to the extent that a dividend is deemed by subsection (12) (determined without reference to subsection (13)) to have been paid in respect of the amount. 7 Legislative Requirements S. 247 Repatriation (13) If a dividend is deemed by subsection (12) to have been paid by a corporation and received by a non-resident person, and a particular amount has been paid with the concurrence of the Minister by the non-resident person to the corporation, (a) the amount of the dividend may be reduced by the amount (in this subsection referred to as the reduction ) that the Minister considers appropriate, having regard to all the circumstances, and (b) subsections 227(8.1) and (8.3) apply as if (i) the amount of the dividend were not reduced, and (ii) on the day on which the particular amount was paid, the corporation paid to the Receiver General an amount equal to the amount that would be required to be withheld and remitted under Part XIII in respect of the reduction. 8

5 TPRC Committee Committee created by policy and not law Membership Penalty Recharacterization TPM 13 TPM 09 9 TPRC Statistics Executive Summary as of December 17 th, (3) Penalty Referrals Penalty Recommended % Penalty Not Recommended % Total 247(3) Cases Referred % 247(2)(b) Re-characterizations Denied/Abandoned % Approved % Ongoing % Total Cases Referred % 10

6 Reasons for Penalty Timing Material Omissions of Key Transactions Wrong Tested Party Transacting Against Contemporaneous Documentation Functional Analysis Differing from Contemporaneous Documentation 11 What to do when embarking on preparing contemporaneous documentation? Understand your transactions (T106) Take inventory of what already exists global studies? local studies, old or current? agreements? Do a risk assessment Assemble documentation 12

7 Risk Assessment Can you conceive of an adjustment that exceeds the lesser of: 10% of revenue? $5 million? 13 Example 1 Canco is a Canadian distributor of its US parent s products sales of $50M global study indentifying subsidiaries as routine distributors from 3 years ago TNMM sample range 1% to 7% CanCo made 4% operating margin Is it possible there could be a $5 million adjustment? Conclusion: Low risk; Hand over global study, Canadian P&L; internally prepared Canadian functional analysis; update comparables financial results. 14

8 Example 2 Canadian manufacturer/distributor licenses the US parent s TM and technology for a 6% royalty sales of $800M; royalty in $48M historically profitable but rocky results for past 3 years reliance on 3 rd party CUP in Mexico at 5% closed 2 of 7 divisions and moved operations to the US. Conclusion: High risk; minor adjustment (1%) can cause penalty. 15 Example 2 cont d Royalty analysis must be robust and meet the expectations of the new OECD guidance (see TPM 14) Detailed functional of Canadian operation and how it benefits from the use of the intangibles Detailed financial analysis explaining why recent performance is not an indicator that the intangibles value has diminished Detailed economic analysis following OECD 9 step process; Mexican CUP must be made comparable; (i.e. adjusted upwards) Division closures must be addressed using the guidance in Chapter IX to explain rationale for no compensation. 16

9 OECD 9 Step Process: 1. Determination of years to be covered. 2. Broad-based analysis of the taxpayer's circumstances. 3. Understanding the controlled transaction(s) under examination based in particular on a functional analysis, in order to choose the tested party (where needed), the most appropriate transfer pricing method to the circumstances of the case, the financial indicator that will be tested (in the case of a transactional profit method), and to identify the significant comparability factors that should be taken into account. 4. Review of existing internal comparables, if any. 5. Determination of available sources of information on external comparables where such external comparables are needed taking into account their relative reliability. 6. Selection of the most appropriate transfer pricing method and, depending on the method, determination of the relevant financial indicator (e.g., determination of the relevant net profit indicator in case of a transactional net margin method). 7. Identification of potential comparables: determining the key characteristics to be met by any uncontrolled transaction in order to be regarded as potentially comparable, based on the relevant factors identified in Step 3 and in accordance with the comparability factors set forth at paragraphs of the OECD Guidelines. 8. Determination of and making comparability adjustments where appropriate. 9. Interpretation and use of data collected, determination of the arm's length remuneration. 17 Comparability factors: Characteristics of property or services Contractual terms Business strategies Economic circumstances Functions performed, assets used and risks assumed 18

10 Practicality; where do you draw the line? reasonable efforts in accordance with the same prudent business management principles that would govern the process of evaluating a business decision of a similar level of complexity and importance [OECD p 5.3] The taxpayer should not be expected to have prepared or obtained documents beyond the minimum needed to make a reasonable assessment of whether it has complied with the arm s length principle [OECD p 5.7] level of review of TNMM Comparable Companies? level of review of inexact CUPS for licensing? 19 Questions for the CRA How does CRA know whether documents were prepared contemporaneously; vs after the CD request? Do you have examples of where penalties were levied on this issue? 20

11 Questions for the CRA Selection of the tested party. Taxpayer selects Canadian organization as least complex party. CRA argues that foreign parent should be tested party or combination should be considered under profit spilt methodology. What circumstances could make TPRC impose a penalty in this situation? 21 Questions for the CRA cont d CRA agrees with the taxpayer s method ie TNMM, but by adjusting the comp set, gets a range which the taxpayer falls outside What circumstances could make TPRC impose a penalty in this situation? Does CRA now use full range or IQ range? Multiple year averaging allowed? 22

12 Questions for the CRA cont d Taxpayer used TNMM claiming routine contract manufacturer CRA argues CUP, using similar product pricing What circumstances could make TPRC impose a penalty in this situation? 23 Questions for the CRA cont d Taxpayer used TNMM to build a return; Sales and Mktg + Distribution + R&D CRA argues CUP based on one unrelated agreement that they believe to be comparable What circumstances could make TPRC impose a penalty in this situation? 24

13 Questions for the CRA cont d Canadian taxpayer closed a division as part of a restructuring, and consolidated production in US plant that had spare capacity. No intercompany transactions were recorded CRA considered this disposition of goodwill and performed a valuation that computed goodwill of $40 million What circumstances could make TPRC impose a penalty in this situation? What if the taxpayer had done a valuation? 25 Questions for the CRA cont d Taxpayer uses set of comparable licensing transactions to create CUP range and concluded royalty was in the range; confirmed with profit split analysis CRA rejected most CUPs except for low ones and taxpayer now out of range What circumstances could make TPRC impose a penalty in this situation? 26

14 Questions for the CRA cont d Auditors referral letter claims; Responses to queries were slow Requests for travel and interviews were denied Further adjustments to CUPs were required What circumstances could make TPRC impose a penalty in this situation? 27