New Guidance Issued by Canada Revenue Agency Requires Taxpayer Caution
On January 29, 2015 the Canada Revenue Agency (“CRA”) issued two memoranda providing guidance to field auditors when performing transfer pricing audits: Transfer Pricing Memorandum 15 (“TPM-15,” Memorandum on Intra-group Services) and Transfer Pricing Memorandum 16 (“TPM-16,” Memorandum on Multi-Year Data). Although both memoranda are intended to clarify existing rules, they may signal a new emphasis on positions that could deviate from those generally accepted among other Organisation for Economic Cooperation and Development (“OECD”) member states. Multinational enterprises operating in Canada should therefore respond proactively.
The guidance provided in TPM-15 and TPM-16 requires that taxpayers take a number of steps to ensure compliance with Canadian transfer pricing rules. First, they should carefully examine the cost bases used for computing outbound service charges to Canadian affiliates. Taxpayers should be prepared for additional scrutiny as TPM-15 may signal a new emphasis on identifying and denying deductions for stock-based compensation or other non-deductible charges included in services cost bases. Multinational enterprises should also revisit any of their existing transfer pricing documentation that relies on interquartile ranges based on three-year weighted averages, and evaluate any potential exposure resulting from the CRA’s rejection of both three-year weighted averages and interquartile ranges. In addition, multinationals doing business in Canada should evaluate their current transfer pricing policies, and revise them on a prospective basis, if necessary, to comply with the positions set out in the TPMs.
In TPM-15, the CRA restates much of the guidance provided in the 1999 Information Circular 87-2R (“IC 87-2R”) with respect to intercompany services and provides more detailed guidance to its field auditors when examining intercompany service charges. Among other things, it states the following:
- Where they can be reliably applied, direct charge methods are preferable to indirect charge methods.
- When using a cost-based method, the services cost base must consist of actual rather than budgeted costs.
- Service cost allocations for management fees should not be based solely on sales, and a “multiple allocation basis” may be more reliable.
Certain costs that may be included in an intercompany service charge but are not deductible under Canadian income tax law are also addressed, including employee stock options and capital expenditures. While a nondeductible expense may be included in an intercompany service charge to a Canadian entity, that entity cannot deduct the expense in Canada. Acknowledging that these provisions may result in double taxation as some of these costs (including employee stock options) must be included in intercompany services cost bases in other OECD countries (including the United States), the CRA states that no treaties or other provisions allow taxpayers to deduct these amounts.
In TPM-16, the CRA’s focus is on taxpayers’ use of interquartile ranges calculated on the basis of three-year weighted averages. Based on the provisions of the OECD Guidelines and the U.S. IRC Section 482 regulations, many taxpayers determine the profits due in connection with a particular service or function by reference to the profits earned by independent enterprises that perform comparable functions. To eliminate any potential distortions resulting from relying only on the results of a single year, these analyses are typically performed on the basis of the last three years of available data. The CRA, however, states that “transfer prices for a given year should be determined based on the results of a single year of data,” and that “taxpayers should not average results over multiple years for the purpose of substantiating their transfer prices in an audit context.”1 Furthermore, TPM-16 objects to use of the widely-relied upon interquartile range on the grounds that its use “is based on the assumption that the comparable transactions, whose observed financial outcomes are outside this range, are not comparable, simply on the basis of these observed outcomes rather than any consideration of the other economic characteristics of the transactions.” The CRA emphasizes that all observed values must be considered, and that, “where no further distinction can be made on the basis of comparability, the most appropriate point may usually be determined by using the average [which] gives equal weight to each observation being considered.”
Multinational companies doing business in Canada will need world-class tax and economic advice as a result of the potential inconsistencies between the Canadian transfer pricing rules and those of other countries— including the United States. The transfer pricing experts at True Partners Consulting and our affiliated firms in the True Partners Consulting International network have the experience and expertise necessary to guide taxpayers through these new challenges.