Canada’s latest federal budget1 signaled an intention to enforce the transfer pricing rules in a greater number of cases, including potentially to arrangements involving arm’s length intermediaries, and in a way that increases the likelihood of transfer pricing penalties being assessed. The 2019 budget measures are the latest in a series of recent developments that should ensure Canada’s reputation for aggressive enforcement of transfer pricing rules remains well earned.
On March 19, 2019, the federal government tabled a budget that included two new measures specific to transfer pricing, reaffirmed Canada’s commitment to the OECD/G20 Base Erosion and Profit Shifting (BEPS) initiative, and included a fourth consecutive wave of additional funding for tax enforcement. Taken together, the budget measures should allow the Canada Revenue Agency (CRA) to conduct a greater number of international tax audits, and in certain cases, to apply the transfer pricing adjustment and penalty rules to a greater number of historic taxation years.
Expanded Definition of “Transaction,” for Purposes of Extended Reassessment Periods
The budget proposed changes to the Income Tax Act (ITA) to ensure that the term “transaction” has the same meaning in the rules governing which tax years remain open for reassessment, as it does in the transfer pricing rules. Canada’s transfer pricing rules are contained in section 247 of the ITA; they provide an ability to adjust transfer prices used for transactions between non-resident parties who do not deal at arm’s length (such as related parties), and for the assessment of corresponding transfer pricing penalties (where certain size thresholds are exceeded). For purposes of section 247 only, the word “transaction” has an expanded definition that “includes an arrangement or event”.
A separate section of the ITA governs how many tax years remain open for reassessment, for example, as resulting from a CRA tax audit. For corporations, the normal reassessment period is typically three or four years from the date of the original notice of assessment. An extended reassessment period is allowed, going back an additional three years, for certain types of adjustments – including those “made as a consequence of a transaction involving the taxpayer and a non-resident person with whom the taxpayer was not dealing at arm’s length.” The 2019 budget proposed changes to this extended reassessment period section, that would define “transaction” the same broad way it has been defined in the transfer pricing rules.
The “transaction” definition change would affect taxation years for which the normal reassessment period ends on or after March 19, 2019.
Observations and Takeaways
For taxpayers involved in relatively complex arrangements, this measure could lead to a greater number of tax years becoming open for reassessment. Consider, for example, an arrangement involving a Canadian taxpayer and its related non-resident, but with an unrelated third party acting as intermediary between the two. Assume that the arm’s length intermediary engages in “back-to-back” transactions with each of the related parties, but there are no direct transactions between the related parties. An expanded definition of the word “transaction” for purposes of the extended reassessment period, explicitly including an “arrangement” involving two related parties, may be more likely to allow an additional three years for the CRA to make transfer pricing reassessments related to such an arrangement – in a similar manner to a simpler example in which the same related parties had transacted directly with each other.
There have been other recent changes to Canadian tax provisions that were originally limited to transactions directly between a Canadian taxpayer and a non-resident who are not dealing at arm’s length, but were later expanded to cover scenarios involving third parties. For example, the 2014 budget introduced ITA changes that essentially ensured taxpayers could no longer avoid the thin capitalization rules for interest deductibility by imposing an arm’s length intermediary between the Canadian payor of interest and a related non-resident lender. In 2013, a new provision was added to the transfer pricing rules, creating an exclusion from arm’s length pricing requirements for certain guarantee fees that may be receivable by a Canadian resident from a controlled foreign affiliate, pertaining to loans provided to that controlled foreign affiliate by an unrelated third party; the previous form of this exclusion only applied in cases where the Canadian taxpayer made a loan directly to its controlled foreign affiliate. These two examples essentially took a Canadian tax provision that had previously applied only to direct transactions between two parties who do not act at arm’s length and extended that same treatment to more complex arrangements that include unrelated parties as well.
Taxpayers engaging in “arrangements” that involve related non-residents, but without entering into direct transactions with the related non-resident, may want to consider the level of risk related to potential transfer pricing adjustments – especially for tax years beyond the normal reassessment period.
The 2019 budget also proposed a new measure intended to clarify that the transfer pricing rules within section 247 should be applied before the application of any other rules within the ITA.
Canada’s transfer pricing rules reflect the arm’s length principle and can be used to change certain amounts used in calculating the income of a Canadian taxpayer, such as the amounts paid or received in transactions with a related non-resident. With a few exceptions, the transfer prices charged in such transactions must be the same used if the parties had been dealing at arm’s length. If adjustments are made under the transfer pricing rules, increasing the Canadian taxpayer’s income beyond certain thresholds, then the assessment of transfer pricing penalties must also be considered. Exemption from such penalties is possible if the taxpayer can demonstrate it made “reasonable efforts” to determine and use arm’s length prices, including by preparing contemporaneous documentation.
Other provisions of the ITA could apply to similar transactions, with similar effect. For example, other provisions of the ITA work to limit certain deductions to a “reasonable amount,” or require the Canadian taxpayer to pay or receive “fair market value” when transacting with related parties. However, these other ITA provisions do not explicitly incorporate the arm’s length principle, nor do they create exposure to the same potential transfer pricing penalties.
The new ordering rule would stipulate that in cases where both the transfer pricing rules and other provisions could apply, the transfer pricing rules of section 247 should be applied first.
The existing exceptions to the arm’s length principle within the transfer pricing rules, pertaining to certain debts or guarantees involving controlled foreign affiliates, will continue to apply.
This provision would apply to tax years beginning on or after March 19, 2019.
Observations and Takeaways
This new measure has the potential to increase the number of tax audit cases in which transfer pricing penalties are assessed, and potentially to increase the amount of such penalties. In some past cases, tax audit adjustments that could have been made under the transfer pricing rules of section 247 were reassessed, in whole or in part, under other provisions of the ITA instead. In those cases, the transfer pricing penalties did not apply, or would apply only on a smaller subset of adjustments, perhaps even falling below the size thresholds for penalties to be considered at all.
Considering this new budget measure, taxpayers should expect that any audit adjustments that could be made under the transfer pricing rules will be made under those rules, increasing the likelihood that corresponding transfer pricing penalties could also apply (if the adjustments exceed certain size thresholds). This change potentially increases the value of maintaining contemporaneous documentation, since such documentation is a necessary condition to qualify for the “reasonable efforts” exemption to transfer pricing penalties.
Commitment to the Base Erosion and Profit Shifting Initiative
No legislative changes were proposed relating to the OECD/G20’s BEPS initiative. However, the 2019 budget reaffirmed Canada’s commitment to “safeguarding Canada’s tax system,” and to remain an active participant in the BEPS initiative.
Country-by-country report exchanges commenced in 2018 and Canada is participating in an OECD review of the quality of these initial reports, with the review expected to be completed in 2020.
Canada has signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI), along with 86 other jurisdictions to date.
Observations and Takeaways
Canada’s response to the BEPS initiative has not yet involved significant changes to the local transfer pricing rules, other than the introduction of country-by-country reporting requirements in 2016. This could mean that the Canadian government is confident it can address the transfer pricing concerns raised by the BEPS initiative within the existing legal framework.
In our experience, Canadian tax auditors have been raising similar transfer pricing concerns as are described in the BEPS initiative since well before the first BEPS action plan was released.
A Fourth Wave of Additional Resources for Tax Enforcement
The 2019 budget proposed to allocate an additional $150.8 million over five years to the CRA to fund new enforcement initiatives and existing programs such as:
Hiring additional auditors;
Targeting non-compliance associated with the digital economy; and
Extending programs aimed at combatting offshore non-compliance.
These latest investments are expected to generate $369 million of additional federal government revenues over five years, plus additional revenues for the provinces and territories.
The 2019 budget also proposes to invest $65.8 million over five years to improve the CRA’s information technology systems, to help “fight tax evasion and aggressive tax avoidance.”
The 2019 budget continues a trend observed each year since the OECD released its final reports from the BEPS action plan in October 2015. Since then, each of Canada’s annual federal budgets have included substantial new investments in the government’s international tax enforcement capabilities, each of which are expected to drive higher levels of local tax revenue collected from taxpayers.
The 2016 budget included over $444 of new funding for the CRA over five years, including for the hiring of new auditors and economists, focusing on audits of high-risk multinationals and expecting to generate $2.6 billion of new federal revenue in the same period.
The 2017 budget proposed more than $593 million of new funding for tax enforcement over five years, including for additional auditors and risk-assessment systems for international tax, driving expected additional federal revenue of $2.5 billion.
The 2018 budget increased funding for the federal court system by over $41 million, mostly directed toward the Tax Court of Canada.
Canadian members of multinational groups could reasonably expect that international tax audits will continue to increase in both number and frequency, with an emphasis on transfer pricing.
These continued investments in expanding the CRA’s enforcement capability come with expectations of generating billions of dollars in new federal revenue, beyond the status quo, which suggests Canada’s reputation for taking aggressive transfer pricing positions against taxpayers is likely to continue.
For a personal discussion of these or any other transfer pricing issues, and how they could affect you or your company, please contact the Canadian Transfer Pricing team.