27 February 2025 CTF Seminar - Transfer Pricing

This summarizes some of the CRA responses given to questions posed to it at the February 27, 2024 Transfer Pricing Seminar of the Canadian Tax Foundation held in Toronto. The questions were posed by John Tobin of Tories LLP.

CRA Panelist:

Frédéric Bourgeois, Director, International Tax Division, International and Large Business Directorate, Compliance Programs Branch

Comparables

In its supporting documentation the taxpayer should not simply state that agreements with third parties were reviewed and none were found to be sufficiently comparable to reliably apply the comparable uncontrolled price (CUP) method using comparable transactions, and instead references to such agreements should be provided and an explanation given.

Size and penalties

The Transfer Pricing Review Committee (TPRC) takes the size of the taxpayer and the size of the transaction into account in determining whether to penalize, although these are only a factor in the consideration.

Reasonable efforts

The documentation should be prepared before the documentation due date, and failure to do so is often one of the reasons why a penalty is imposed. All information that is listed in s. 247(4) should be provided including the functional analysis.

Non-application of penalties

In the April 2024 to January 2025 period, 16 of the 48 cases referred to the TPRC did not result in a penalty recommendation. Where the taxpayer has done its analysis and all the facts are there and the disagreements relate to what screen should be used for comparables or what databases should be extracted, generally these are the cases where the TPRC will not penalize. Similarly, if there are disagreements between two sides’ valuation experts, there should be no penalties for that.

“Delineation” of a transaction

Consistent with the transfer-pricing guidelines (TPG), the delineation process requires outlining what has actually occurred between the parties, not simply a description of the legal agreement.

While the inter-company agreement can be a good starting point, what is needed is a detailed outline of what the parties actually did in terms of functions, assets consumed, and risk assumed; what they did for one-another, did separately, and how all this resulted in the creation of value in the business.

Commercial rationality of a transaction

Commercial rationality, which is also linked to the transfer pricing analysis, can really be understood as an economic test. It asks whether arm’s length parties acting in a self-interested, commercially rational manner, would have entered into the transactions with stated terms and conditions under the economic circumstances that they are each operating under. Each party would take into account the options realistically available for their business in their decision-making as to whether to enter into a transaction and what should be the terms and conditions of the transaction.

Therefore, commercial rationality requires consideration of the reasonable expectations of the best possible outcome for the entity. For the purpose of documenting commercial rationality of a transaction, taxpayers should provide an economic discussion to explain the nature of the transaction and should include consideration of the history of the arrangement and the activity of the broader market to justify the tested party’s decision.

Ultimately, the purpose of the inquiry is to determine whether the arrangement would have been agreed to by unrelated parties. As stated in the TPGs, the key question in the analysis is whether the related party arrangement exhibits the commercially rational terms and conditions that would be agreed between unrelated parties under comparable economic circumstances.

Who bears the risk?

Lastly, on the concept of who bears the risk, CRA would not, at first, differentiate between inbound (Canadian subsidiary) and outbound (Canadian parent) transactions. The transaction is analyzed in its totality. Generally, duly staffed and funded incorporated businesses are responsible for the risks that are inherent in their business and have the financial capacity to bear the risk. Any interaction with a related party carries compensation for the services that are provided, commensurate with the risk of providing the service as determined by a comparability analysis.

Generally, CRA sees risk as linked to the functions and assets. That is, the risk follows the functions and the assets, and the taxpayer’s efforts to decouple risk from functions and assets, as if risk were some form of commodity to be traded, is troublesome and not in CRA’s view how the TPGs should be interpreted and applied.

Determining how risk should be treated in a transaction will require consideration of the delineation exercise mentioned earlier, combined with an understanding of the economically relevant characteristics and the industry at large.

Taxpayer submissions

The taxpayer should be able to reproduce its analysis and should make its representations as clear as possible, including why the taxpayer disagrees with the auditor.

TPRC decision-making

The Director (Frédéric Bourgeois) is the ultimate decision maker, but he typically seeks input from Department of Justice representatives and managers, where applicable.

Industry expertise and projects

Industries for which the International Tax Directorate has focused on developing expertise include mining, oil and gas, farming, banking, insurance and reinsurance. Tools used to elicit facts include queries, functional interviews, websites, industry reports, court cases that are not related to tax, and information from treaty partners.

Effect of enhanced audit powers

Not much has changed, although there is less pushback from taxpayers on CRA doing functional interviews. Once the Budget 2024 changes are enacted, CRA will be developing policies in consultation with industry.

Interviews and notes

The CRA audit manual prohibits auditors from being recorded, and asks them to leave if they are being recorded. That said, that policy is under review, and having a transcript of a functional interview could be beneficial to both parties.

Simplified documentation for smaller taxpayers and transactions

The Australian tax authority has been doing good work in this area, but it remains to see what Finance (Canada) decides to do.

Hybrid mismatch rules

CRA is working on a webpage, which should be available shortly, that will describe what is required of taxpayers caught up in these rules. The webpage will list the prescribed information that is required to be attached to the return.

Country-by-country (CbC) reporting

The CbC information is being shared with auditors in the field and is being used in CRA’s risk assessment system. When filing a CbC report, “no TIN” (taxpayer identification number) is to be used only when the constituent entity does not have a TIN, and use in any other circumstances may result in penalties and requirement to refile the report.

S. 231.1 information demands

It is not normal for the initial audit query to be issued pursuant to section 231.1, but auditors are free to do so.

CRA has experienced taxpayers requesting that information requirements to them be made pursuant to s. 231.1 in order to access exceptions in commercial agreements for disclosures compelled by law.

Taxpayers should not panic if they receive a s. 231.1 demand - they won't be in the Federal Court two weeks later.