Three basic forces drive the Canadian transfer pricing regulatory environment: 

Section 247 found in Part XVI.1 of the Act provides the legal framework for transfer pricing in Canada. It contains the following subsections:

Subsection 247(1) defines the terms used throughout the section.

Subsection 247(2) explains the calculation of transfer pricing adjustments. The transfer pricing adjustment is basically equal to the difference between the taxpayer's transfer price and the transfer price that would have been agreed to by arm's length parties for the same transaction.

Subsection 247(3) explains the calculation of a penalty. The penalty can only be applied if the net adjustment exceeds the lesser of $5,000,000 and 10% of the taxpayer's gross revenue for the year. The penalty is essentially 10% of the net adjustment of the transfer price for which the taxpayer did not make a reasonable effort to determine and use arm's length prices [i.e. no (or insufficient) contemporaneous documentation was prepared].

Subsection 247(5) deals with the partners' gross revenue for the purposes of penalty calculation in Subsection 247(3).

Subsection 247(6) is a deeming rule "looking through" stacked partnerships.

Subsection 247(7) excludes loans to a subsidiary caught under Subsection 17(3) from the application of a transfer pricing adjustment in Subsection 247(2).

Subsection 247(8) states that Section 247 takes precedence over Sections 67 and 68 and Subsections 69(1) and 69(1.2).

Subsection 247(9) is a penalty anti-avoidance section.

Subsection 247(10) allows the Minister to exercise his/her discretion in respect of the transfer pricing adjustment. This subsection allows for the varying of adjustments resulting from a competent authority consideration as provided under numerous tax treaties.

Subsection 247(11) states that Sections 152, 158, 159, 162 to 167 and Division J of Part I apply to Part XVI.1.

It is important to note that although all the subsections relating to transfer pricing adjustments are effective for taxation years that begin after 1997 (when they replaced the previously used Subsections 69(2) and 69(3)), all the penalty subsections are effective for taxation years that begin after 1998.

Aside from the sections of the Act dealing with international tax (such as Part XIII, Part XIV, etc.) it is important to consider statue limitations as specified in Subsections 152(4). Barring the exceptions (e.g. misrepresentations, fraud, waiver, etc), the limit for assessments and reassessments involving the transactions between the taxpayer and non-resident non-arm's length party is 6 years for CCPC and 7 years for non-CCPC. Note that the Mutual Agreement article of many Canadian tax treaties allows for a shorter period of time. Consequently, in some rare cases, it might be difficult to take a reassessment to the competent authority review.

The CCRA's views about transfer pricing are stated in the Information Circular 87-2R (IC 87-2R). The Circular, which provides a major explanation of transfer pricing rules in Canada, has 12 parts. The following is a brief overview of the IC 87-2R. It is necessary to read the full IC prior to the preparation of any transfer pricing documentation or dealing with any other transfer pricing issues.

Introduction - Specifies that the IC 87-2R follows Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrators issued by the Organization for Economic Co-operation and Development in 1995. These guidelines should be consulted for a more detailed discussion of the principles when necessary.

Part 1. The Law - Provides a brief description of the principal subsection in Section 247 of the Act.

Part 2. The Arm's Length Principle - Explains the arm's length principle, discusses the comparability issues, and states that the arm's length principle should be applied on a transaction-by-transaction basis. It also discusses bundling, unbundling and re-characterization of transactions.

Part 3. Methods - Application of the Arm's Length Principle - States that in the CCRA's view there is a "natural hierarchy of methods", discuses the methods, comparability issues and adjustments. The methods discussed include Comparable Uncontrolled Price Method, Resale Price Method, Cost Plus Method, Profit Split Method, and Transactional Net Margin Method. It also states that the Comparable Profit Method (CPM), often used in the United States, "will be acceptable in Canada, subject to the natural hierarchy of methods...and to the extent that its application conforms to the comparability standards set forth for Transactional Net Margin Method in the OECD Guidelines."

Part 4. Qualifying Cost Contribution Arrangements (QCCA) - Defines the QCCA, specifies conditions for QCCA participants (such as an expectation to derive a benefit from the results of QCCA), discusses benefit sharing, allocation keys, buy-ins and buy-outs.

Part 5. Intangible Property - Specifies that the overall expected benefit is key in the determination of transfer prices for intangibles. It discusses comparability issues and other difficulties relating to an intangible property. However, it also specifies that despite these difficulties the use of hindsight to determine values of intangibles is not appropriate.

Part 6. Intra-Group Services - Describes the services provided by one member of the group to the other members, specifies conditions when the charge for such services is justified, and discusses mark-up on the charges and allocation methods to determine the charges.

Part 7. Penalty - Reasonable Effort - Explains the calculation of the penalty, situations where the taxpayer has not made a reasonable effort or is deemed not to have made it. Furthermore, this part describes some of the items the CCRA expects to be included in general transfer pricing documentation as well as the items expected to be included in QCCA documentation, documentation in respect of intangible property and some business strategies.

Part 8. Confidentiality of Third Party Information - Deals with so-called "secret comparables" (i.e. information on comparable transaction(s) obtained by the CCRA from another taxpayer which cannot be disclosed to the audited taxpayer).

Part 9. Part XIII Withholding Tax - Discusses implications of transfer pricing adjustments for withholding under Part XIII of the Act and conditions of granting a relief from Part XIII tax.

Part 10. Competent Authority Procedures - Explains the relief available under Article IX of most tax treaties and specifies that there is no relief for the transfer pricing penalty. Further information on competent authority procedures is provided in Information Circular 71-17, Request for Competent Authority Consideration Under the Mutual Agreement Procedures in Income Tax Conventions.

Part 11. Advance Pricing Arrangements - Introduces the CCRA's Advance Pricing Arrangements (APA) program. Further information on APAs is provided in Information Circular 94-4R, International Transfer Pricing: Advance Pricing Arrangements (APAs).

Part 12. Customs Valuation - States that the CCRA is not obliged to accept the value reported for duty for transfer pricing purposes.

Most of the transfer pricing audits proceed through the following four stages:

During this pre-audit stage the CCRA screens the files for a potential international audit. The selection of the file might be based on a T106 filing (e.g. question 6 of T106 slip answered as no, or omitted, transfer pricing method specified as 7 or omitted), a referral from other audit sections, special projects, part of the ordinary audit, etc.

Once the file is selected for an international audit, the auditor will review the volume and type of transactions, all the related files and filings, and consider the risk of non-compliance and the materiality of transactions (company size, transaction size, potential recurring losses of the Canadian entity, transactions with tax havens, etc). Next, the taxpayer is contacted and asked for the transfer pricing documentation and the auditor begins to prepare an audit plan.

During the information gathering stage the auditor reads through the transfer pricing documentation, gains understanding of the industry and the company's position in the industry, examines the legal structure of the group, tours the plant(s), and looks for any obvious comparable transactions (internal and external).

The auditor also reviews accounting and tax records, issues the preliminary queries and starts conducting interviews with company's staff. In general, the auditor identifies the material issues and attempts to collect as much information as necessary for the development of his/her own functional analysis and selection of comparable transactions.

During this stage the auditor test checks the transfer pricing policies as specified in the documentation by following the flow of documentation related to the transaction (i.e. "cradle to grave" approach). The auditor also develops his/her own functional analysis and questions or confirms the functional analysis as provided by the taxpayer. He/she identifies comparable transactions, considers the appropriateness of the taxpayer's comparable transactions (or companies), and identifies and quantifies any potential adjustments.

In some cases, the auditor does not develop his own economic analysis, but he/she only critiques the perceived or actual shortcomings of the taxpayer's documentation. The auditor may also ask for support from the CCRA specialists (economists, valuators, etc.). The auditor issues further queries and discusses the potential areas of disagreement with the taxpayer. It is important to note that once the information analysis stage is over, it is usually extremely difficult to alter the auditors' position on contentious issues.

During the resolution stage the auditor issues a so-called "30-days letter" proposing the adjustments to be made. This letter allows the taxpayer to react to the proposed adjustments, discuss the proposal with the auditor, and supply new evidence if necessary. Since transfer pricing is not an exact science, many of the transfer pricing differences may be settled at this stage by negotiating with the auditor or his / her team leader.

The auditor is required to issue a tax assessment before the statue of limitation comes into force and, consequently, as the statue barred date is approaching, the CCRA representatives are more anxious to issue the final reassessment. It is possible, although not always recommended, to issue a waiver to the CCRA and thus extend the time necessary for the presentation of supplementary evidence and negotiations. At the end of the audit the taxpayer will receive a Notice of Reassessment specifying the adjustments and taxes payable.

When the taxpayer does not agree with the reassessment, he/she may request a competent authority consideration (if an applicable tax treaty exists) and / or file a Notice of Objection. If the transaction was with a non-treaty country, the Notice of Objection is the only route. If the transaction was with a treaty country, the taxpayer should ask that the Notice be put in abeyance pending the competent authority decision.

If the taxpayer is not comfortable with the competent authority decision, he can proceed to the appeal stage. Note that only a minimal number of appeal officers have in-depth knowledge of transfer pricing, and, therefore, appropriate steps should be taken to ensure that an informed appeal decision is obtained.

If the taxpayer is not satisfied with either the competent authority decision, or with the appeals result, and is unable to negotiate a reasonable settlement of the issues, the case may be taken to court (firstly Tax Court of Canada, then Federal Court of Appeal, and then Supreme Court of Canada). Since most of the transfer pricing issues are settled at the audit or appeal stage, there are only a few transfer pricing precedents in Canada. This fact, together with the fact that transfer pricing as a highly specialized part of the tax system is not encountered by the judges too often, increases the risk of an adverse outcome in the court system.

The CCRA's views on competent authority procedures are stated in the Information Circular 71-17R4 (IC 71-17R4). The following is a very short overview of the IC 87-2R. One should read the full IC prior to the preparation of any submission to the competent authority.

Introduction - Explains that the Canadian taxpayer may request competent authority assistance under Canadian tax conventions.

Tax commitment of the Canadian competent authority - Defines the competent authority as the Minister or the Minister's authorized representative.

Request for competent authority consideration - Describes the conditions of the request, lists the information that should be provided with the request, and provides the mailing address.

Acceptability of requests - Stipulates the conditions under which the competent authority will attempt to assist to the taxpayer.

Responsibilities of the Canadian taxpayer - Discusses the responsibilities of the taxpayer, such as filing waivers and keeping the Canadian competent authority informed about all new and / or changed information and documentation.

Notification of reassessment pursuant to Article IX, "related Persons", of the Canada-U.S. Income Tax Convention (1980) - Explains the procedures under Article IX. of the treaty.

Competent authority settlements - Discusses the purpose of the settlements and specifies that they are not precedent setting.

Interest payable and penalties on Canadian income taxes - Specifies that Canadian tax treaties do not cover interest and penalties, and thus these payments will not be waived as a general practice.

The repayment of funds and Part XIII tax - Deals with the repayment of deemed dividend free of any withholding tax.

The appeals pertaining to reassessment initiated by Revenue Canada - Discusses the policies with respect to competent authority consideration when the taxpayer proceeds with the notice of objection or appeals to the court.

Tax appeals in foreign countries - Specifies that the Canadian competent authority is not bound by the decision of foreign courts.

Provincial income tax considerations - Lists the agreeing provinces (note that this list was relevant as of May 12, 1995, so there have been some subsequent changes) and discusses the applicability of the conventions to the agreeing and non-agreeing provinces.

Advanced Pricing Arrangement (APA) is an administrative approach that attempts to prevent transfer pricing disputes from arising by determining the transfer price(s) prior to the transactions taking place. As such, the idea is similar to the advance income tax rulings. The idea of an APA is to reach an agreement prior to the transaction, whereas an ordinary audit examines the transaction after it takes place. An APA term is usually three to five years, although the terms can vary depending on facts and circumstances. The principal intent of the APA program (as stated by the CCRA) is to:

• avoid potential double taxation;
• help taxpayers determine appropriate transfer pricing methodologies (TPMs) for transactions or arrangements they participate in with non-resident persons with whom they do not deal at arm's length for purposes of the Act; and
• serve as a key approach to resolving transfer pricing disputes.

When you comply with the terms and conditions of an APA, the CCRA considers that the results of applying the agreed transfer pricing methodology have satisfied Section 247 of the Act for the transactions and periods specified in the APA. With respect to transactions covered by an APA, no penalty will be levied under Subsection 247(3) of the Act for taxation years during which the APA remains in force. Also, the APA program may be used to resolve transfer pricing controversies for the years included in the audit.

The benefit of an APA is a "certainty of treatment" in terms of the transfer pricing issues which assists companies in avoiding double taxation and penalties. The APAs are usually conducted on a bilateral or multilateral level, thus securing the predictable treatment in all the countries involved.

On the other hand, the full potential of this program is being diminished by the lengthy and costly approval process for each applicant. This may make the program unappealing to small and mid-sized companies. However, we have been informed by a CCRA representative that a simplified, less costly version of the APA will be available to smaller companies in the future.

Another potential problem with the APA is that the APA documentation may be used in any subsequent audit even when the APA request was withdrawn by the taxpayer, or the APA was cancelled or revoked. Although the APA program remains separate from the audit program and a request for an APA does not trigger the initiation of an audit, all the information obtained or generated during the APA process is "for the purposes of administering the [Income Tax] Act."

The recently issued revised IC 94-4R International Transfer Pricing: Advance Pricing Arrangements (APAs) provides an excellent description of the APA process with many useful Appendices. The IC 94-4R fully endorses the OECD guidelines for APAs as provided in OECD's 1999 publication entitled Administrative Approaches to Avoiding and Resolving Transfer Pricing Disputes (actually an appendix to OECD's 1995 Transfer Pricing Guidelines). The following is a brief overview of the IC 87-2R. One should read the full IC prior to considering an APA.

Introduction - explains the role and purpose of APAs and provides the glossary of terms and abbreviations.

Part I - Purpose and scope of APAs - Describes the APA process, its stages, the potential for retroactive application of an APA and the conditions for APA requests.

Part II - Prefiling meeting(s) - Describes the prefiling meeting conditions and deadlines.

Part III - Processing an APA request - Explains the procedures relating to accepting, declining or withdrawing APA requests. It also discusses non-refundable user charges, as well as the composition of the CCRA's APA case teams.

Part IV - Content of an APA submission - Provides information about general and specific items to be included in an APA submission.

Part V - Case work and resolution - Deals with the review, analysis and evaluation of taxpayers' documentation submitted for the APA, CCRA's competent authority negotiations, and post-settlement meeting.

Part VI - Competent authority consideration - Discusses general issues relating to bilateral and multilateral APAs.

Part VII - Legal effect - States that the APA is binding on the CCRA and on the taxpayer. An APA also provides a "safe harbour" against the imposition of penalties under Subsection 247(3) of the Act.

Part VIII - Use, disclosure and protection of information - States that all information obtained during the APA process is for the purpose of administering the Act, and the confidentiality of all information is protected under the Act and the relevant tax treaties.

Part IX - Administering an APA - Deals with APA reporting to the CCRA, possibility of compensating adjustments, audit procedures relevant to the APA, dispute resolutions, revisions, cancellations, revocations and renewals of APAs.

Part X - Other references - Lists complementary Information Circulars.

Part XI - Further contact - Provides the CCRA's APA related contacts.