Recent developments in Canadian transfer pricing.

I. Overview

This article reviews three recent developments respecting Canadian transfer pricing law and practice. Two concern transfer pricing-related penalties, and the associated notion of preparing contemporaneous documentation; and the third deals with taxpayer-initiated downward adjustments related to excessive inbound prices or insufficient outbound prices.

Canada, like the United States, regulates cross-border intercompany transactions on the basis of the "arm's-length principle," rejecting (like most other countries) the alternative of formulary apportionment law and methods. (1) In light of the facts-and-circumstances nature of the principle, the Canadian tax statute does not lay down (directly or through statutorily-authorized regulations) any implementing rules, (2) in contrast to the United States whose governing "regulations" were promulgated pursuant to section 482 of the Internal Revenue Code. (3) In the absence of specific statutory rules for applying the arm's-length principle, Canada Customs and Revenue Agency (CCRA) takes the position that determinations are to be made in accordance with the transfer pricing "methods" developed (mainly on the basis of the U.S. regulations) by the Organisation for Economic Cooperation and Development (OECD). (4) This CCRA view is set forth in a non-binding "information circular." (5)

With effect for the 1999 taxation year, Canada has followed the lead of the United States (some three years earlier) by adopting specific transfer pricing-related penalties, with the associated notion that the timely preparation of contemporaneous documentation may provide a safe harbor from such penalties. (6)

In light of the subjectivity--and hence uncertainty--stemming from the facts and circumstances nature of the basic "rule," it is not surprising that (1) there have been no court decisions in either country since 1962 involving a Canada-U.S. transfer pricing issue, (2) generally, disputes involving Canada and the United States are either resolved at domestic audit or through competent authority procedure, and (3) in the early 1990s (again at the initiative of the United States) both Canada and the United States (and both then and later, many other countries) have tried to take the uncertainty out of the equation by agreeing, in advance of disputes, through advance pricing agreements. (7)

Even in areas where Canada and the United States are ostensibly at odds, the unifying effect of the essential character of the principle has substantially tempered such differences. In particular, since 1992 the United States. has ostensibly been lined up against Canada, and the balance of the OECD, respecting the role of CPM. Nevertheless, the almost twin cousin developed by the OECD (the net transactional margin method (TNMM)) has not only mainly dissolved the conflict, but in its September 1999 revised information circular, CCRA reluctantly acknowledged that in some circumstances CPM (and not merely its twin TNMM) might be appropriate. (8)

Although there are several other factors that could be considered to be part of Canadian transfer price law and practice, the foregoing should serve to provide an adequate framework to consider the three recent developments in Canada.

II. Recent Developments Related To Penalties And Documentation

A. Background

With effect in 1999, there is a transfer price related penalty, equal to 10 percent of the amount by which Canadian income has been understated because of transfer prices not conforming to the arm's-length principle. (9)

The penalties can only apply (with respect to transactions on current account) where (1) income has been understated by an amount exceeding the lesser of CDN$5 million or 10 percent of the gross sales (of goods or services) of the relevant Canadian party, and (2) the taxpayer did not make "reasonable efforts" in arriving at those "wrong" transfer prices. (10) In contrast to the United States, the penalty can apply, regardless of whether there is taxable income in the year.

As in the United States, there is no positive statutory test respecting "reasonable efforts," (11) but the requirements will be deemed not to been satisfied if the taxpayer has not prepared, by the time it has to file its tax return for the tax year in question (which is six months after the tax year end), "records or documents" (i.e., documentation) as set out in section 247(4) of the Act. Preparing such documentation, however, does not automatically mean the taxpayer will be considered to have made "reasonable efforts."

B. PATA Agreement on Documentation

On March 12, 2003, the Pacific Association of Tax Administrators (consisting of Australia, Canada, Japan, and the United States) released a package of transfer pricing-related documentation rules, which are intended to minimize the cost and burden of preparing multiple documentation otherwise required under the domestic law of each of the four countries. Although the PATA rules intimate that compliance with the documentation requirements will serve as a guarantee against transfer price related penalties, the "small print" of the rules disabuses the reader of that possibility, at least from the Canadian standpoint.

Before the PATA agreement, there was clearly a question in Canada whether such documents prepared for purposes of another country (often the United States) would be acceptable in Canada. One difference between the two countries, for example, is that the Canadian requirements fall into six categories whereas the U.S. approach is delineated between principal documents and background documents, entailing ten categories. It is the burden of preparing multiple sets of documents under differing rules in respect of the same transaction that prompted PATA members to negotiate an agreement that will permit a multinational operating in two or more of these countries to prepare a "single package" of documentation related to relevant intercompany transactions. This initiative should decrease the compliance costs of multinationals operating within the four countries. But there is one problem with the package.

Aspects of its language suggest that taxpayers utilizing the PATA documentation package will have certainty that they will not be exposed to penalties, even if their prices are wrong. That would change the result in Canada, inasmuch as documentation prepared in accordance with section 247(4) of the Canadian Income Tax Act does not, by itself, provide a safe harbor against penalties. As previously explained, section 247(4) requires both that and the making of "reasonable efforts," which itself is a subjective matter. This implication of certainty comes out of the following language in, and related to, the package.

A CCRA press release (12) announcing the March 12 PATA agreement, states:

   The PATA documentation package is intended to
   reduce taxpayer burden and provide certainty that
   a penalty will not be imposed. Use of this PATA
   documentation package is completely voluntary
   and, if the principles are satisfied, will protect the
   taxpayer from transfer pricing documentation
   penalties that might otherwise apply in each of
   the four jurisdictions. (Emphasis added.)

Similarly, the Introduction to the agreement itself provides:

   The PATA members, after reviewing their respective
   domestic laws regarding transfer pricing and
   documentation of controlled transactions, agree
   that a multinational enterprise ("MNE") will satisfy
   each PATA member's documentation provisions
   by complying with all of the principles contained
   in this PATA Documentation Package, and
   will thus avoid the imposition of the PATA members'
   transfer pricing penalties with respect to the
   documented transactions among associated enterprises
   resident in PATA member jurisdictions.

   By providing taxpayers with the option of applying
   this uniform documentation package, the
   PATA members intend to assist taxpayers to efficiently
   prepare and maintain useful transfer pricing
   documentation, and timely produce such documentation
   upon request to PATA to member tax
   administrations while precluding any related
   transfer pricing penalties. (Emphasis added.)

The implication of these statements is that preparing the relevant documentation is all that it takes to avoid penalties. (13) The PATA initiative, however, does not change the requirement to deal with the (subjective) question whether "reasonable efforts" have been made. Thus, the section of the agreement entitled "The PATA Documentation Package" states that "in order to avoid the imposition of PATA member transfer pricing penalties," it is necessary to "satisfy three operative principles." The first stated principle is the "need to make reasonable efforts, as determined by each PATA member tax administration, to establish transfer prices in compliance with the arm's length principle." (Emphasis added.)

Therefore, Canadian taxpayers are not relieved by the PATA agreement from the untested "reasonable effort" requirements of subsection 247(3).

C. Quebec Repeals Its Penalties

When the Department of Finance crafted the penalty rules in 1998, it assumed they would not be replicated or added to by the provinces, which occupy roughly 25 percent-40 percent of the overall federal and provincial corporate field tax. In May 2001, however, the province of Quebec enacted a transfer-pricing law that essentially comports with the usual approach, except that it also enacted transfer price penalties at the same rate as the federal, 10 percent. (14) This meant that, since the corporate tax rate payable to the province on profits from an active business is 9 percent, the penalty was actually more than 100 percent of the otherwise-applicable tax.

Indeed, if applicable, the Quebec penalty would have meant--in respect of a company carrying on business in Quebec and paying (after 2003), say, an overall aggregate federal and provincial rate of tax of 31 percent--a twin penalty of 20 percent, which would be two-thirds of the basic corporate tax! In contrast, in the overall U.S. or Canadian federal context (and leaving aside the 40-percent penalty regime in the United States for excessive understatement) the penalty works out to be about 20 or 30 percent of overall federal and provincial or overall federal and state taxes.

Discussions with Quebec officials respecting this obvious inequity spawned assurances that they would try to negotiate a coordinated approach with Ottawa. (15) Whatever the basis, in March 2003, the Quebec government announced in its 2003-2004 Budget that it would repeal, retroactively, its obviously inappropriate penalty rule, as follows (page 95, section I of the supplementary budget papers):

   Transfer pricing rules are aimed at protecting Canada's
   tax base by encouraging taxpayers to adhere
   to the arm's length principle. In accordance with
   this principle, the terms and conditions of trans-border
   taxations concluded between a Canadian
   taxpayer and a non-resident related to the taxpayer
   must be comparable to those concluded between
   parties that are independent of one another.

   When the conditions of transborder transactions
   do not adhere to the arm's length principle, adjustments
   may be made to the income of the Canadian
   taxpayer. In addition, federal tax provisions
   provide for a penalty when transfer pricing adjustments
   exceed a minimum threshold and the
   taxpayer had not made a reasonable effort to determine
   and use arm's length transfer prices. In
   brief, this penalty, whose rate is 10%, applies to
   the net transfer pricing adjustments.

   Transfer pricing rules have been included in the
   tax legislation of Quebec and other provinces that
   administer a corporate tax system. However, the
   provisions pertaining to the penalty have not been
   included in the legislation of the other provinces.

   In this context, for the purpose of fostering inter-provincial
   neutrality, the tax legislation will be
   amended to abolish the 10% transfer pricing penalty
   retroactive to its effective date.

III. Downward Pricing Adjustments: CCRA Communique

The focus of a recent CCRA communique publication, "Downward Transfer Pricing Adjustments under Subsection 247(2)," (16) is downward adjustments in income, resulting from inaccurate prices, sought by a taxpayer. The matter may involve set-offs that arise unintentionally, where one intercompany transaction has resulted in an overstatement of income (by reason of an inappropriate transfer price) and another (or more than one) has understated the income (by reason of an inappropriate transfer price). Such circumstances will generally be identified upon audit, and the question is the manner in which such situations are dealt with and, in particular, whether one can appropriately be off-set are against the other, thereby producing a net adjustment? (17)

This matter is now ostensibly fully dealt with under sections 247(2) and (10). (18)

A threshold factor is the notion suggested by section 247(2) and the preferences of the supporters of the OECD Transfer Pricing Guidelines that, at least in theory, determinations are to be made on a separate transaction or a transaction-by-transaction basis. This approach, in theory, militates toward the three orthodox transaction-based transfer pricing methods--CUP, (19) cost-plus, or resale method--and away from profit-based methods, whether TNMM (or CPM) or profit splits--the very antithesis of a transaction-based approach. That is the theory. In practice, however, at least in Canada, CCRA's predilection to evaluate pricing by reference to the Canadian unit's share of the overall MNE's profits arising from intercompany transactions often sees the CCRA turning to the ostensibly unprincipled approach of a profit split, as a means of resolving the matter. It is obvious that such aspect of a dispute, by its very nature, eliminates the legal question whether one transaction offsets another. (20)

Downward adjustments (sometimes involving set-offs) are now bound up in a strange statutory rule, enacted in 1998, which is stated to operate only at the discretion of the government. This is section 247(10) of the Act, part of the 1998 restatement of the arm's-length principle, which reads, as follows:

   An adjustment (other than an adjustment that
   results in or increases a transfer pricing capital
   adjustment or a transfer pricing income adjustment
   of a taxpayer for a taxation year) shall not
   be made under subsection (2) unless, in the opinion
   of the Minister, the circumstances are such
   that it would be appropriate that the adjustment
   be made.

What does that rule mean? And what are its intended effects?

The basic arm's-length rule set out in subsection 247(2) is that where an intercompany price in respect of "a transaction or a series of transactions" does not meet the arm's-length standard, there should be readjustment to the arm's-length standard. (21) Without reference to section 247(10), the basic rule operates to increase or decrease income, but with it, the approval of CCRA is required for the latter. Section 247(10) is a hybrid set-off rule potentially limiting set-offs or separately potentially operating to simply deny a reduction of Canadian taxable income by reason of group prices have overstated Canadian income.

The statute does not provide any guidance respecting the manner in which the Minister is to exercise its discretion under section 247(10), that is, whether the circumstances "are such" that it would be appropriate to allow for the reduction in Canadian income.

There have been prior instances in the Act of the rules granting the Minister discretion in determining tax results for a taxpayer. Disputes over the manner in which such discretion is exercised is bound up in or governed by two separate elements. First, each rule is distinguished from the other by its own particular factors. Second, all such rules are united by the requirement, established more than half a century ago in Wright's Canadian Ropes, (22) that, in exercising his discretionary power, the Minister must act reasonably and in a non-arbitrary fashion. (23) In light of this requirement and the essential nature of why there would be a downward adjustment to be made under subsection 247(2)--namely, an overstatement of income by reference to the arm's-length principle, arising either from an erroneous initial determination by the taxpayer or as a deliberate matter of offsetting another transaction which the parties understated Canadian income--what are the circumstances in which it would be appropriate that an adjustment not be made? It is difficult to fathom such circumstances.

In this respect, before the March 18, 2003, CCRA communique, the only views expressed by the CCRA on the matter were, as follows, in IC-87-2R:

25. Subsection 247(10) provides the Minister with the authority to make downward adjustments. Downward adjustments are made only if, in the opinion of the Minister, the circumstances indicate the adjustments are appropriate.

26. However, the Minister may decide not to exercise his discretion under 247(10) where:

* the taxpayer's request has been prompted by the actions of a foreign tax authority and the taxpayer has the right to request relief under the Mutual Agreement Procedure article of the applicable treaty; or

* the taxpayer's request can be considered abusive.

In elaboration on paragraph 25, the Circular states at paragraph 217:

   The Minister may not find it appropriate to exercise
   his discretion, under subsection 247(10) of
   the Act, to make an adjustment
   under subsection 247(2) of the Act,
   when a foreign revenue authority
   has initiated or proposes a transfer
   pricing adjustment. In such
   cases, the Minister expects the taxpayer,
   under review by the foreign
   tax authority, to seek assistance
   from the Canadian Competent Authority
   to claim corresponding adjustments
   or deductions.

It may be noted that where prices have, inadvertently or otherwise, resulted in understated Canadian taxable income, Revenue Canada expects taxpayers to voluntarily adjust accounts or even past returns to report increased income. (24)

Another question relates to the manner in which set-offs are dealt with in an international context and, in particular, whether the domestic rules of Canada somehow conflict with the requirements under treaties. As well, there is a question about the role withholding taxes might have with respect to an element of transactions involved in a set-off situation.

In principle, there appears to be no reason a treaty would either aid or obstruct (other than in the context of a competent authority proceeding under the terms of Article 9 of an OECD-styled treaty) the set-off issue. There also appears to be no reason the rules relating to withholding taxes on, say, royalty payments would have such an effect. (25)

Finally, an element of this matter that is difficult to assess in light of the enactment of section 247(10) is a decision handed down some 30 years ago that authorized an adjustment to an overstatement of Canadian income, through a compensation payment made several years after the intercompany transaction. As such, this was not a matter of set-off per se but straight correction of a particular overstated transaction. (26)

On March 18, CCRA issued a communique setting out its views on the operation of the discretionary downward adjustment rule of section 247(10) in light of the arm's-length principle requirements of section 247(2). It implies, by referencing situations that arise "during the course of an audit or result from a taxpayer-requested adjustment" that a downward adjustment effectuated by a taxpayer before the filing of a tax return does not require CCRA approval. (27)

Where the issue arises upon audit (after the year is closed and after a tax return has been filed), Revenue Canada would presumably be considering an increase in income because of an inadequate transfer price and the taxpayer counters, pointing to another transaction that was priced in such a way to overstate income. The taxpayer seeks to have the latter taken into account in arriving at net adjustments for the year. In such a case, the issue is generally subsumed in an eventual settlement or competent authority proceeding. If it arises from a taxpayer-requested adjustment, a threshold impediment must be noted. In principle, unless a taxpayer has filed a Notice of Objection within 90-days after receiving a Notice of Assessment or Reassessment, the taxpayer has no right to effectuate a change to a return for the year, even though CCRA does, within certain statutory limitations, have a right to reassess the taxpayer's request for adjustment. (28) Do these factors render section 247(10) of academic interest only?

As previously discussed, CCRA's Information Circular 87-2R stated that the taxpayer's request for a downward adjustment pursuant to the discretionary rule of section 247(10) would likely be rejected where "the taxpayer's request can be considered abusive." The communique now provides examples of what CCRA had in mind in that Circular:

* When a Canadian taxpayer requests an increase in the transfer price of purchases or acquisitions without repatriation being carried out within a reasonable time. This may be considered abusive, as there is an increased expense or cost without any outlay.

* When a Canadian parent company requests a decrease in the transfer price of sales to a nonresident subsidiary without repatriation--This is not considered abusive. The downward adjustment indicates an appropriation of an identical amount from the subsidiary. Subsection 15(1) would apply and offset the downward adjustment. Only through repatriation would the Canadian parent company avoid the application of subsection 15(1).

* When a Canadian parent company requests a decrease in the transfer price of sales to a non-arm's length non-resident without repatriation and subsection 15(1), 56(2), or 246(2) does not apply to the amount. This situation may be considered abusive because the Canadian taxpayer has turned an otherwise taxable receipt of monies into a nontaxable amount.

Significantly, it is an untested question whether a Canadian court would consider such an exercise of discretion to conform to the foregoing principles respecting the exercise by government of any discretion provided it by a statute.

The communique then goes on to specify that, where relevant, adjustments are to be directed to either (or sometimes both) the Director General of the International Tax Directorate (in Ottawa) or the head of a (district) Taxation Service Office. (29) The communique correlates the instruction to six examples (30) and, among other things, distinguishes between adjustments that exceed $500,000 and those that do not.

In light of the role that repatriation or lack of repatriation might play in determining what situations are abusive, the communique both notes the role of Part XIII withholding tax with respect to outbound repatriation payments (e.g., outbound payment of a royalty would attract a 25-percent withholding tax subject to treaty reduction) and the procedures that CCRA acknowledges to constitute repatriation payments. (31)

Finally, the communique notes the relationship between the issues of downward adjustments and repatriation payments under treaty competent authority or exchange of information procedures.

(1) Note, however, recent European Community initiatives in this area, as well as those of U.S. Senator Bryon Dorgan.

(2) Section 247(2) of the Income Tax Act (Canada) R.S.C. 1985, Chap. 1 (5th Supp.) (hereinafter "the Act") adopts the principle by requiring intercompany prices that conform to "those that would have been made between persons dealing at arm's length...."

(3) At this juncture, there is no compelling evidence that this difference between the two countries (i.e., the absence of any detailed rules in Canada) affects the manner in which any particular transfer price issue would be decided by courts in the two countries. In this respect, see the departure from the regulations by the court in E.I. duPont de Nemours & Co. v. United States, 608 F.2d 445 (Ct. Cl. 1979), cert. denied, 445 U.S. 962 (1980), aff'g 7801 USTC [paragraph] 9633 (Ct. Cl. Trial J. 1978).

(4) OECD Committee on Fiscal Affairs, "Transfer Pricing and Multinational Enterprises" (1979). For the revised guidelines, released from July 1995 through February 1998, see Organisation for Economic Cooperation and Development, "Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations."

(5) Information Circular 87-2R, "International Transfer Pricing" (Sept. 27, 1999).

(6) Somewhat ironic (having regard to the fact that the imposition of transfer pricing-related penalties requires a showing by the tax administrators that taxpayers' prices do not conform with the arm's-length principle) is that, except for one case in Canada, neither Canada nor the United States has seen a court decision respecting transfer pricing issues between units of a multinational both operating in high tax jurisdictions. In that 1962 Canadian case, the government lost. See J. Hofert Ltd. v. M.N.R., 62 DTC 50 (T.A.B.) (1962). In Hofert, the court stressed that transfer pricing is nothing but a question of the facts and circumstances where, everything else being equal, the most compelling evidence would be a comparable uncontrolled price (not found in that case) even though that notion had yet to see the light of day in legal orthodoxy. (The decision predated by 6 years the 1968 issuance of the first set of regulations under U.S. section 482 and 17 years before the first OECD Guidelines.) See also "Final Section 482 Rules Likely This Year, Will Not Require the Use of CPI Test, Mogel Says," BNA Daily Tax Report (No. 184), at G-1 (Sept. 22, 1992) (quoting U.S. International Tax Counsel James Mogel that the right answer is a "great deal more flexibility and broad principles from which you can then go to a facts and circumstances analysis").

(7) See Nathan Boidman, "Revenue Canada Releases Details of Advance Pricing Arrangements Program," 54 The Tax Executive 272 (July-August 2001).

(8) Paragraph 115 of IC 87-2R, supra note 5, provides that "CPM will be acceptable in Canada, subject to the natural hierarchy of methods (discussed in Part 3 of this Circular), and to the extent that its application conforms to the comparability standards set forth for the TNMM in the OECD Guidelines."

(9) The Canadian penalty was adopted on the basis of being roughly halfway between the effective amounts of the two-prong U.S. penalty approach (which are roughly equivalent to 7 percent or 14 percent of understated income, depending upon the degree of divergence from arm's-length prices but not computed as a percentage of income but rather as a percentage of the otherwise applicable tax). The dual-level U.S. penalties under section 6662 of the Code are (depending upon the circumstances) 20 percent of tax otherwise payable, say 35 percent (or 7 percent) or 40 percent of such tax (or 14 percent). The penalty provisions became effective February 6, 1996.

(10) Section 247(3) of the Act. In principle, the discussion should relate to roughly only 85 percent of multinationals to the extent that (1) there is accuracy to studies that show that 15 percent of multinationals, actually establish transfer prices through normal businesslike "hard bargaining" and (2) despite the absence of any case law on point in any country, a court would conclude, if convinced of the "hard bargaining" (which itself requires some substantial business reason for units of the same multinational to actually bargain with each other), that such prices constitute the most pristine form of arm's-length price. An informal survey by the author three years ago, involving 15 countries, indicated that there had been no evidence of such a matter going to a court. Those governments (e.g., Canada) or government-sponsored bodies (e.g., OECD) that have given the matter thought reject, without merit in the author's view, the notion that prices determined by real bargaining should preempt any further inquiry.

(11) For CCRA's view, see paragraphs 179 and 198 of IC-87-2R.

(12) "PATA Documentation Package available on CCRA's Website," Canada Customs and Revenue Agency, News Release, March 12, 2003.

(13) The word "intended" in the quoted materials is used, admittedly a potentially equivocal concept, and in the second excerpt there is reference to "all of the principles contained in this PATA Documentation Package," which itself should put the reader on alert.

(14) See sections 1082.3-1082.13 of the Act, basically duplicating federal section 247 and adding, among other things, a separate 10-percent penalty. (See Bill 138, Title I.2.)

(15) Quite apart from the need to radically change or drop the rule, there was also a mechanical deficiency in the initial approach to the rule which did not take into account the fact that a corporation carrying on business in Canada may pay tax to provinces other than Quebec. The deficiency was that the penalty would apply to all income, whether or not allocated to Quebec. The Quebec government did announce in February 2002 that this deficiency would be rectified.

(16) This CCRA Communique was released on March 18, 2003, and according to a report (Alfred Zorzi and Rachel Spencer, "Canada Goes Public With Internal Guidance: CCRA Communique On Downward Adjustments," 11 Tax Management Transfer Price Report 1055 (April 2, 2003), had been prepared initially for internal purposes (issued September 20, 2002) and its existence had been revealed at a December 2002 conference held in Montreal. The text of the communique is on CCRA's website http://www.ccraadrc.gc.ca/tax/nonresidents/business/dtpa-e.html.

(17) The OECD guidelines (at paragraphs 1.60-1.63) deal with "intentional set-offs," described at paragraph 1.60, as follows:

   An intentional set-off is one that associated enterprises
   incorporate knowingly into the terms of the controlled
   transactions. It occurs when one associated enterprise
   has provided a benefit to another associated enterprise
   within the group that is balanced to some degree by
   different benefits received from that enterprise in return.

The commentary continues, in paragraph 1.64, to comment on unintentional set-offs, as follows:

   A taxpayer may seek on examination a reduction in a
   transfer pricing adjustment based on an unintentional
   over-reporting of taxable income. Tax administrations
   in their discretion may or may not grant request. Tax
   administrations may also consider such requests in the
   context of mutual agreement procedures and corresponding
   adjustments (see Chapter IV). (Emphasis added.)

The author does not necessarily agree with the italicized comment, but it can be seen that that factor (discretion) has specifically been built into Canada's revised transfer pricing rules, pursuant to section 247(10) of the Act.

(18) It was not clearly treated under the pre-1998 provisions of sections 69(2) and (3). CCRA's pre-existing view was that the prior law did not provide taxpayers the right to set offs and this is reflected in paragraph of the March 18 communique, which states:

   [B]efore the existence of subsections 247(2) and (10),
   downward transfer pricing adjustments required the involvement
   of Canada's Competent Authority of the presence
   of contractual price adjustment clauses.

The author is involved in an administrative appeals matter where the merits for set-off, notwithstanding the structure of the pre-1998 law, has been advanced. The matter has now been pending for several years.

(19) Comparable uncontrolled prices.

(20) That profit splits may be a handy tool for the CCRA to raise or support a transfer pricing reassessment is reflected in the manner in which the CCRA, in its latest (September 1999) "circular" on transfer pricing (IC-87-2R) devotes abundant space and attention to (and adopts) the original U.S. (1988 White Paper) residual profit-split method, having due regard to the 1994 revision of the section 482 regulations in the United States and the revised OECD Transfer Pricing Guidelines issued in 1995-1996.

(21) The notion of "series of transactions" was apparently intended to have, built in, a basis for intentional set-off in relation to pre-ordained inter-dependent transactions within a group.

(22) Wrights' Canadian Ropes and Minister of National Revenue, [1946] S.C.R. 139, also 2 DTC 794.

(23) The Supreme Court in Wrights adopted principles of the U.K. House of Lords, as follows:

In Sharp v. Wakefield, [1891] A.C. 173, at 179, Lord Halsbury said:

   "Discretion" means, when it is said that something is
   to be done within the discretion of the authorities,
   that that something is to be done according to the
   rules of reason and justice, not according to private
   option: Rooke's case; according to law, and not humour.
   It is to be, not arbitrary, vague, and fanciful,
   but legal and regular.

(24) See paragraphs 15, 16, 27, 191, and 192 of the Circular. Informal discussions with one of the principal drafters of the rule suggests that the purpose of attempting to restrict income reductions (and set-offs) under subsection 247(10) was to provide an incentive to Canadian companies to document their transfer prices. It is in those circumstances that the Minister will react favourably. But if that is the purpose, it is a well-kept secret! Nothing on the face of the statute suggests such a correlation between the rule of subsection 247(10) and the preparation of contemporaneous documentation, whereas the relationship of the latter to the 10-percent penalty rule of subsection 247(3) is specifically provided for.

(25) An adjustment under section 247(2) is said to be for the purposes of the Act and, as such, should be treated as deemed amounts for the Act, which presumably include the terms of Part XIII (dealing with withholding taxes and outbound passive income payments). Subject to a contrary intention, the normal definitional renvoi to domestic law under Article 3(2) of a typical OECD-styled treaty should produce the same effects under a treaty. Informal discussions with one of the principal drafters of the rules, however, confirm that there was a concern that adjustments under subsection 247(2) would not apply for purposes of Part XIII, so that taxpayers could deliberately understate outbound royalty payments to affiliated parties reduce Part XIII tax therein and then claim a reduction of income by way of an adjustment under subsection 247(2) without paying Part XIII tax. If that were possible, one could see a role for subsection 247(10). There appears, however, to be no basis for such interpretation. For example, where a Canadian company has paid insufficient royalties to a foreign parent and there is an adjustment to increase the amount considered paid by the Canadian subsidiary for purposes of computing its taxable income in Canada pursuant to section 247(2), it appears that such adjustment would be considered to constitute a payment that would trigger a 25-percent withholding tax under Part XIII of the Act with respect to royalties paid to a nonresident, subject to reduction or exemption by the terms of Article 12 of a treaty between Canada and the country of the parent.

(26) Aluminium Co. of Canada Ltd. v. The Queen, 74 DTC 6408 (F.C.T.D.), where the Canadian parent had underpaid its Jamaican subsidiary for the supply of raw material. Following an assessment by the Jamaican tax authorities, the parent in a subsequent year made a payment to compensate for the prior underpayment and deducted that payment in the year in which it was made. Revenue Canada challenged the deduction, but it was upheld by the Federal Court Trial Division. The dispute did not involve a straight underpayment but rather a complex series of transactions which the Court construed to be an underpayment for purposes of dealing with the parent's compensating payment. There appears to be no evident relationship between (or manner of correlating) constraints imposed by subsection 247(10) with respect to a same year downward adjustment (where Revenue Canada is given the rights to deny same otherwise required by section 247(2)) and an adjustment of an overstatement of income by way of a compensation payment in a subsequent year with a claim for relief thereof in that subsequent year as dealt with in the Aluminum Co. case.

(27) This view is expressed by Zorzi & Spencer, supra note 16, at 1055-56:

   [U]nder subsections 247(2) and 247(10) of the Act, a
   taxpayer and CCRA are precluded from adjusting the
   taxpayer's transfer prices to reduce its reported income
   or increase its costs after a return is filed unless the
   Minister of National Revenue concurs with the adjustment.

   [A] taxpayer is, in principle, required to determine its
   income for the year and to report this income for tax
   purposes in its timely filed tax return. Administratively
   the CCRA allows a taxpayer to self-assess a downward
   adjustment during the year or subsequent to the
   end of the year and prior to filing its return of income
   for the year.

(28) This is dealt with in Information Circular 757R3, Reassessment of a Return of Income.

(29) Section 220(2.01) of the Act: "The Minister may authorize an officer or class of officers to exercise powers or perform duties of the Minister under the Act." Under this rule, CCRA has delegated to the Director General of the International Tax Directorate and Director of a tax services office (i.e., a district office) the authority to exercise the discretions under section 247(10).

(30) The six examples set out various fact patterns that might arise.

(31) The communique describes repatriation payments, as follows:

Repatriation can be accomplished by:

* offsetting inter-company liabilities [this method of repatriation may have a ripple effect on other items such as intercompany interest charges];

* the transfer of money or its equivalent to the nonresident corporation;

* where a Canadian parent company cannot effect repatriation within a reasonable time, the creation of a shareholders loan account [this would be effective at the date of the transfer-pricing transaction and may result in the application of subsection 15(2) of the Act]; or

* netting upward and downward transfer pricing adjustments from different non-residents if both the taxpayer and all the non-residents involved agree in writing to have the amounts offset."

NATHAN BOIDMAN is a partner with Davies Ward Phillips & Vineberg LLP in Montreal. He has been a frequent contributor to The Tax Executive and numerous other publications.