Canada and U.K. propose arm's-length transfer pricing rules.

The Canadian government has proposed arm's-length transfer pricing legislation that would bring the country's transfer pricing rules in line with the July 1995 international transfer pricing guidelines of the Organization for Economic Cooperation and Development (OECD).

The proposed amendments would also impose documentation requirements and stiff penalties for taxpayers that failed to make reasonable efforts to document their transfer pricing practices. The arm's-length requirement, which would replace the current transfer pricing rules requiring related-party transactions to be based on what is a "reasonable amount" under the facts and circumstances, would apply to corporate taxpayers and partnerships for any transactions in tax years starting after 1997.

The proposed legislation would rely on the two types of arm's-length methods recommended by the OECD: (1) the traditional transaction methods (i.e., comparable uncontrolled price (CUP) method, resale price method and cost plus method); and (2) the transactional profit methods (i.e., the profit split and transactional net margin methods).

The Canadian government endorses the view of the OECD guidelines that the traditional methods are preferable to the transactional profit methods and that the latter should only be used as methods of last resort (i.e., when the use of traditional methods would not produce a reliable arm's-length price). If applicable, the CUP method is endorsed as providing the highest degree of comparability.

A de minimis rule protects taxpayers from the new provisions if the total fair market value of the properties or services involved in the tax year or reporting period does not exceed C$1 million.

Taxpayers would be required to prepare documents on all transfer pricing transactions within 60 days of the end of the tax year, and to provide those documents to Revenue Canada within 60 days of a written request to do so. The proposed legislation would create a penalty for failing to make reasonable efforts to determine and use arm's-length transfer prices in cross-border transactions. The penalty would apply when the total of a taxpayer's reduced transfer pricing income and capital adjustments for the year exceed the lesser of 10% of gross revenues for the year or C$5 million.

The penalty would be 10% of the amount of the "reduced" transfer pricing income and "capital adjustments." Much simplified, the penalty would be 10% of the pricing adjustment, rather than 10% of the Canadian tax actually collected. Thus, the penalty could apply to Canadian companies with no income tax liability in Canada even after the transfer pricing pricing adjustment. By contrast, in the U.S., transfer pricing penalties are a percentage of the tax, rather than a percentage of the adjustment.

The proposed legislation was expected to be introduced in the Canadian Parliament in late 1997.

U.K. Proposal

The U.K. government has proposed similar legislation that would bring the country's transfer pricing rules in line with OECD guidelines. The proposed amendments would not impose new documentation or penalties; rather, taxpayers would be expected to rely on OECD guidelines in determining how much documentation needed to be created and retained; current tax penalties for fraud and negligence would be used to police the arm's-length standard.

In contrast to the U.S. and proposed Canadian rules, taxpayers would not be subject to specific transfer pricing documentation and penalty rules. Inland Revenue has stated that taxpayers should rely on OECD guidelines in determining how much documentation is required. The OECD has stated that transfer pricing documentation should be the same as that which a prudent business management would create and maintain in evaluating a complex and important business decision. For example, taxpayers will be expected to create and retain information on which their transfer prices were based, the factors taken into account and the pricing method selected. No specific legislation is being sought for obtaining pricing-related documents. Instead, Inland Revenue officials expect to continue to rely on general information-gathering authority.

In the same vein, no new penalties are being sought. Instead, Inland Revenue wild rely on current penalties for and negligence, which can equal the amount of the tax lost as a result of the fraudulent or negligent conduct.

In addition to the adoption of arm's-length pricing, the proposed legislation would end the practice of "directions," which currently restrain examiners from reviewing a taxpayer's transfer pricing unless there is prior approval from the Inland Revenue Board. To replace the "directions" as a check on government abuses or unwarranted transfer pricing reviews, the government said it would adopt a central monitoring system within Inland Revenue.

The proposal did not include a provision to adopt a formal Advance Pricing Agreement procedure, hut the government intends to continue the current informal procedure for granting such rulings under tax treaties.

The government did not announce the effective date for its proposed changes.

FROM MICHAEL F. PATTON, WASHINGTON, D.C.