Canadian release increases fears of U.S.-Canadian transfer pricing disputes.

I. Introduction

On January 7, 1994, Canadian Finance Minister Paul Martin and National Revenue Minister David Anderson issued a News Release clarifying the application of the Canadian income tax rules and guidelines for determining transfer prices between members of an international corporate group. The Release, which was issued in response to U.S. transfer pricing developments, raises serious questions about the potential for double taxation in Canadian/U.S. cross-border pricing matters.

For some time, senior Canadian government officials have expressed concern about the potential for double taxation and the possible inability to resolve intercompany pricing disputes with the United States in light of the 1993 temporary and proposed regulations under section 482 of the U.S. Internal Revenue Code/ This, coupled with the comments made by the Organisation for Economic Cooperation and Development in its December 1992 and April 1993 reports, has heightened concern in Canada.

II. Canadian Transfer

Pricing Principles

In international transactions between related parties (and other persons not dealing at arm's length), the Canadian Income Tax Act (ITA) requires that the amount paid or received be an amount that "would have been reasonable in the circumstances if the nonresident person and the taxpayer had been dealing at arm's length."(3) The ITA, however, does not provide any guidelines or tests. The administration and enforcement of these provisions are left to the Department of National Revenue (Revenue Canada)(4) and, ultimately, to the Canadian courts. Reasonableness is a question of fact. Few Canadian cases have gone to court and, accordingly, there is little law on which to rely. The Canadian approach, however, does leave open the application of all factors. To the extent that the U.S. regulations restrict or limit the factors that may be brought into account or impose a non-arm's length type of test, there may be conflict between the Canadian and U.S. rules.

Administratively, Revenue Canada has adopted the 1979 OECD guidelines(5) and, in respect of transfers of tangible property, has looked to the comparable uncontrolled price (CUP) method, the resale-price method, the cost-plus method, and other methods. Other methods typically follow a functional analysis and can involve profit splits. There is no priority given to any particular method, except that CUP is normally applied if reasonably comparable transactions are available.

In respect of intangible property, IC-87-2 outlines methods that essentially mirror those in the pre1993 U.S. regulations(5) and, absent a comparable uncontrolled transaction, suggests a consideration of all factors, including prevailing rates in the industry, terms of the license, singularity of the invention, services provided, anticipated profits to be received by the licensee, and benefits to the licensor from sharing information on the experience of the licensee.

III. Tensions Between Canadian

and U.S. Rules

Against this background, there are a number of potential conflicts between the Canadian rules and the U.S. regulations that must be considered. One of the most basic is the regulations' focus on the results of a transaction rather than whether an unrelated party would have entered into the transaction. To a significant extent, the U.S. regulations look to the former and Canada has typically focused on the latter.(7) Because the U.S. approach involves hindsight , it arguably deviates from the arm's-length standard.

The second potential conflict relates to the ability to use various methods in the regulations. While the "best method rule''s is the general standard, there are a number of circumstances where taxpayers will be compelled to use the comparable profits method (CPM) rather than one of the OECD-sanctioned methods. For example, the CUP method may be used when it is reasonably applied on the basis of available information and there are only minor (ie., immaterial) differences between the controlled and uncontrolled transactions. Thus, "material" differences invalidate this method, even if their effects on price can be reasonably ascertained.(9) Use of this method is also excluded where there are speculative differences (i.e., differences that do not have a "definite and reasonably ascertainable" effect on price).(10) Another significant difference relates to the requirement for taking into account "alternatives reasonably available to a buyer and seller" (e.g., whether to license a subsidiary to manufacture or to perform the manufacturing at the parent level).(11) This represents an administrative reversal of the Bausch & Lomb decision(12)(where actual arm's-length transactions were used) and is arguably inconsistent with the Canadian interpretation of the arm's-length standard. Further, the regulations require the aggregation of "interrelated" transactions (e.g., the license of a manufacturing intangible and the sale of the manufactured product),(13) whereas Canada has insisted on a transaction-by-transaction approach in most cases. In addition, the U.S. regulations usually deem the CPM to give rise to an arm's-length result, thereby giving the CPM an edge in many cases.(14)

The resale-price method, although not subject to CPM testing, is not available if the distributor has added substantial value (e.g., through the use of marketing rights).(15) Thus, the regulations may preclude the use of this method in many circumstances. This should not be the case in Canada.

The CPM has been endorsed by the U.S. regulations as an independent method. It assumes that arm's-length prices will result in profits that are normal within the particular industry. Canada, in contrast, appears to be unwilling to accept the fundamental premises underlying the CPM.

Fourth methods, such as profits splits, that are being used in Canada have come under severe restrictions in the United States. For example, to use a profit-split under the U.S. regulations,(16) both parties must own valuable, nonroutine intangibles, and those intangibles must contribute significantly to the earnings of profits. There must be significant transactions between the parties, and, in addition, there are a number of procedural requirements that must be met. None of these rules is specifically required by Revenue Canada. Thus, profit-split methods normally used in resolving disputes in Canada may not be relied upon in the United States.

IV. Concerns Raised by

the Canadian Release

A. Overview

The Release focused on two main concerns: (1) the introduction and prominent role given the CPM as a basis for determining transfer prices; and (2) the provision for "periodic adjustments," based on profits, of amounts payable for intangible property under agreements lasting for more than one year.

These rules are described as problematic and possibly not acceptable in OECD countries, including Canada. The Release reiterates that the best way to establish a transfer price that is consistent with the arm's-length principle is to examine directly the price charged by arm's-length parties. It recognizes that in some situations the circumstances of a transaction between group members may differ from those involving a transaction with a third party. When the differences can be measured on a reasonable basis, it is still appropriate to use comparables, which are then described as "inexact comparable uncontrolled prices."

The Release confirms the use of the resale-price and cost-plus methods as well as the use of a fourth method to allocate profits of the group based on a proper remuneration of functions performed by different entities within a corporate group.

B. Concerns Related to the

Comparable Profits Method

The Release takes issue with the CPM, in particular for the assumption that a taxpayer using arm's-length prices necessarily has financial results comparable to other companies in the same industry. The Release argues that many factors make it unlikely that this assumption will be accurate. It then refers to the OECD Task Force Report, which identified a number of factors that make profit performance comparisons defective in determining allocations of profit, including:

* Varying cost efficiencies, such as differences in the age of plant and equipment;

* Differences in the quality of management;

* Differences in the cost of capital where some companies rely substantially on internally generated funds, while others may borrow heavily; and

* The degree of business experience, since matured companies would generally have different results from start-up companies.

As a result, the CPM might not generate a transfer price in accordance with the arm's-length principle as understood internationally. Further, the Release points out that the CPM looks only at the functions of one part of the international group, thereby ignoring the relationships between the group's members and the functions carried on by other members. The Release offers the observation, perhaps correctly, that if the CPM were applied by all countries, each country would compare results with independent firms operating in its jurisdiction. The total of the allocations to the different countries could then easily exceed the total income of the group, resulting in over-taxation of the group.

C. Concerns Related to Periodic Adjustments

The second major concern of the Release is the U.S. statutory requirement of periodic adjustments. The commensurate-with-income standard was introduced into the Internal Revenue Code in 1986 with respect to the transfer of intangible properties.(17) Basically, it requires that in the case of any transfer or license of intangible property, the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible. The U.S. regulations have implemented the commensurate-with-income standard by requiring periodic adjustment to contractually agreed prices in order to reflect later year fluctuations in the income attributable to the transferred intangible, subject to some exceptions.(18) The ITA does not require periodic adjustment. Therefore, along with many other countries, Canada views the U.S. requirement as contrary to the arm's-length standard and, at least in Canada's case, giving rise to the potential for more double taxation disputes.

The U.S. regulations have taken steps to assuage previous concerns by widening the exceptions for periodic adjustment. If the transaction was

essentially arm's length in the first year, the functions performed by the transferee have not changed substantially, and the profits in the open years are between 80 and 120 percent of the projected profits for the open years, thin periodic adjustments will generally not be necessary.(19) Notwithstanding this tempering of the U.S. rules, there is still considerable scope for Canadian companies to be penalized when faced with a U.S. pricing adjustment. This concern is reflected in the Release. Quoting from the OECD Task Force Report, it states:

There is a fundamental contradiction between the

arm's length standard which depends upon evalu-

ating transactions at the time they take place and

the commensurate with income concept to the ex-

tent that it involves a year-by-year retrospective

reappraisal based on profits.

The Release then states that when the United States applies the periodic adjustment rule to propose an assessment, Revenue Canada will not automatically provide a corresponding adjustment. The Release does, however, leave open the possibility that there will be a corresponding adjustment. Presumably, the U.S. adjustment must fall within the range of what would be considered reasonable in Canada to trigger a Canadian adjustment.

D. Relieving the Potential for Double Taxation

The Release suggests several steps to relieve the potential for double taxation. First, a company should use a pricing method that is accepted in both countries and that provides the best indication of the price that would be negotiated between arm's-length parties. The Release refers to the CUP, resale-price, and cost-plus methods as examples of methods that meet these conditions. This seems to be addressed to the Canadian corporations within a group. Even in Canada, however, it is often difficult to find a comparable transaction or one that fits the resale-price or cost-plus methods. Accordingly, in many instances, it has been necessary to go to profit-split methods.

Second, the Release states that a company should encourage its U.S. affiliates to use transfer pricing methods that are acceptable under both Canadian and U.S. law. This again may be a relatively simplistic approach. In many cases, the Canadian companies are subsidiaries of large U.S. corporations carrying on business in countries throughout the world. It is less than certain that the group's worldwide transfer pricing structure will be altered to accommodate the Canadian company. Moreover, the U.S. regulations simply may not permit the use of transfer pricing methods that are acceptable in Canada as a result of the restrictions imposed on the use of various methods. Accordingly, while the Canadian companies are advised to encourage U.S. affiliates in this regard, the potential for such change remains dubious.

Third, the Release states that a company should avoid establishing a price using the CPM approach without ensuring that the price that was established represents an arm's-length price. This is clearly going to be difficult. There is often not a comparable, and any method has some judgmental and subjective elements.

The Release suggests that it is advisable to contemporaneously document the basis for selecting a method and the steps taken in establishing a price, since subsequent audits may be conducted well after the prices have been determined. This will be necessary under the U.S. regulations in any event. Indeed, the need to document contemporaneously the basis for selecting a method has increased significantly in the United States as the result of 1993 changes to the penalty rules for transfer pricing adjustments.(20) Canadian companies need to consider what documentation to keep in Canada and the extent to which they will provide it to Revenue Canada on audit.

Finally, the Release suggests that consideration be given to the use of Advance Pricing Agreements. These are becoming increasingly popular in Canada, with interest growing in response to the uncertainty caused by the U.S. regulations.

V. Conclusion

The importance of the U.S. regulations to Revenue Canada is seen in the last paragraph of the Release. First, it provides that if the United States reassesses a U.S. affiliate company using the new rules relating to the CPM and periodic adjustments, Revenue Canada will generally not be able to provide a corresponding adjustment. The Release is unclear on which cases would be exempted from this rule. It does propose the use of competent authority where the CPM has been used and Revenue Canada cannot provide a corresponding adjustment, but states that "Canada will then seek agreement on the application of an internationally accepted pricing method which satisfies the arm's length principle." This suggests that Canada would not agree to the CPM, even at the competent authority level. Rather, Canada would try to negotiate with the Internal Revenue Service to come to a method satisfactory to both parties. Interestingly, the U.S. competent authority's operating instructions in handling allocation cases are to be "guided by," but not bound by, the regulations and to consider all the facts and circumstances, including the purpose of the treaty to prevent double taxation.(21)

In summary, Canada appears to be taking a fairly hard-line position with respect to the regulations. It remains to be seen whether Canada would be prepared to live with a result based on one of its own methods which also provides a price within the CPM range as determined by the United States. Recent remarks by Revenue Canada officials suggest that the apparent conflict in views may not be insurmountable in the competent authority setting. Some of this optimism may be attributable to an anticipated softening in the U.S. rules when final regulations are issued. In the meantime, multinational corporations must be cognizant of the potential for double taxation in this area and try to comply with the Canadian as well as the U.S. rules. Notes

1 Temp. Reg. [sections]8 1.482-1T through 1.482-5T; Prop. Reg.[sections]1.4821T(f)(2) and 1.482-6T.

2 Committee on Fiscal Affairs, OECD, The U..S. Proposed Regulations Dealing with Tax Aspects of Transfer Pricing within Multinational Enterprises, executive summary reprinted in Bulletin of the International Bureau of Fiscal Documentation (Jan. 1993) (OECD Task Force Report); Committee on Fiscal Affairs, OECD, Intercompany Transfer Pricing Regulations Under U.S. Section 482 Temporary and Proposed Regulations, reprinted in Bulletin of the International Bureau of Fiscal Documentation (Nov. 1993).

3 ITA 88 69(2) and (3).

4 Administratively, Revenue Canada has issued "International Transfer Pricing and Other International Transactions," Information Circular 87-2 (Feb. 27, 1987) (IC-87-2).

5 OECD, Transfer Pricing and Multinational Enterprises (1979).

6 Treas. Reg. [section] 1.482-2A.

7 For example, the regulations' comparable profits method (Temp. Reg. [sections] 1.482-5T)--which looks to whether the transfer prices for tangible or intangible property result in a profit level like that of comparable companies--is ordinarily presumed to be an independently valid method that is arm's length (Temp. Reg. [sections] 1.482-5T(a)). It may also be important as a "tie-breaker" for purposes of determining which of two of the more traditional methods will yield a price that is considered closest to arm's length (Temp. Reg.[sections] 1.4821T(b)(2)(iii)(B)). Similarly, the regulations' rules for determining the price for transfers of intangible property can require periodic adjustments to the contractually agreed transfer price, based on later year fluctuations in the income attributable to the intangible. Temp. Reg. [sections] 1.482-4T(e)(2).

8 The "best method" is the "method that provides the most accurate measure of an arm's-length result under the facts and circumstances of the transaction." Temp. Reg. [sections] 1.482-1T(b)(2)(iii)(A).

9 Temp. Reg. [sections]1.482-3T(b)(2)(i) and (iv), Ex. 6.

10 Temp. Reg. [sections] 1.482-1T(c)(2)(ii).

11 Temp. Reg. [sections] 1.482-1T(c)(3)(iv)(A).

12 Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525 (1989), aff'd, 933 F. 2d 1084 (2d Cir. 1991).

13 Temp. Reg.[sections] 1.482-1T(d)(3)(i).

14 Temp. Reg.[sections] 1.482-ST(a).

15 Temp. Reg. [sections] 1.482-3T(c)(1).

16 Prop. Reg. [sections] 1.482-6T(b).

17 See I.R.C. 88 482 and 367(d), as amended by the Tax Reform Act of 1986, Public Law No. 99-514, [sections] 1231(e).

18 Temp. Reg. [sections] 1.482-4T(e)(2).

19 Temp. Reg. [sections] 1.482-4T(e)(2)(ii)(B).

20 See I.R.C. [sections] 6662(e), as amended by the Omnibus Budget Reconciliation Act of 1993, Public Law No. 103-66, [sections] 13236; see also Temp. Reg. [sections] 1.6662-6T.

21 See Rev. Proc. 91-23, 1991-1 C.B. 534, [sections] 3.03; Internal Revenue Manual 42(10)(11).3(2)(b).