Photo of Rami PandherBy Rami PandherJuly 27 2017
Tax Law

Beware of Transfer Pricing Penalties

Click here to view in PDF.

Content from this article was first published by the Canadian Tax Foundation in (2016) 6:3 Canadian Tax Focus and in (2017) 7:2 Canadian Tax Focus.

Introduction

The Canada Revenue Agency (“CRA”) has increased its audit activity surrounding medium-sized private businesses operating internationally. Any company engaging in cross-border transactions with its subsidiaries must consider the transfer pricing implications. Companies without a proper transfer pricing policy may be surprised to learn of the penalties that can be imposed if they are not prepared.

The transfer pricing rules outlined in section 247 of the Tax Act apply to any transaction (or a series of transactions) between a taxpayer (or partnership) and a non-resident person with whom the taxpayer (or partnership or a member of the partnership) is not dealing at arm’s length. A 10% penalty may be imposed if an adjustment under subsection 247(2) exceeds a de minimis amount: the lessor of 10% of the taxpayer's gross revenues for the taxation year or $5 million (herein the “PenaltyThreshold”).[1]

Reasonable Efforts

Transfer pricing is not an exact science. The transfer pricing penalty provision is aimed at balancing the “reasonable efforts” made by taxpayers in setting and documenting arm's length terms and conditions for intercompany transactions rather than focusing solely on accuracy. Subsection 247(3) must also be read in conjunction with subsection 247(4), which deems a taxpayer not to have made reasonable efforts unless the taxpayer has compiled with certain contemporaneous documentation requirements.

Penalties will not apply if requirements within subsection 247(4) are met and reasonable efforts have been made to determine and apply the arm’s length transfer price or arm’s length allocation.[2] However, taxpayers are deemed not to have made reasonable efforts if the contemporaneous documentation requirements under subsection 247(4) are not satisfied. Thus, taxpayers of all sizes must be prepared to demonstrate to the CRA that they have complied with subsection 247(4) and made reasonable efforts to determine and use arm’s-length transfer prices.

Referrals to the Transfer Pricing Review Committee

The CRA’s Transfer Pricing Review Committee (“TPRC”) determines whether reasonable efforts have been made, which is a question of fact. Taxpayers can make one written submission to the TPRC, but there is no opportunity for taxpayers to appear in person to argue the merits of their case.

All adjustments exceeding the Penalty Threshold are subject to a mandatory referral to the TPRC to ensure a consistent application of the rules. Penalties cannot be assessed unless they are approved by the TPRC. As of October 2016, the TPRC had 643 penalty referrals, recommending the penalty be applied in 247 instances.[3]

Case Law

Although the transfer pricing provisions were enacted in 1997, there has only been one case before the courts where transfer pricing penalties were specifically at issue (Marzen Artistic Aluminum Ltd. v Canada, 2016 FCA 34; aff’g. 2014 TCC 194).[4]

Marzen demonstrates that even relatively small companies are not safe from transfer pricing audits and penalties. The taxpayer was merely $25,190 over the Penalty Threshold. The Tax Court concluded that the taxpayer was deemed not to have made reasonable efforts because it failed to fulfill the documentation requirements of subparagraphs 247(4)(a)(v) and (vi). Ultimately, since the Tax Court reduced the reassessment by USD 32,500, penalties were not applied because the revised adjustment fell below the Penalty Threshold.[5]

The jurisprudence underscores the importance of properly determining economic profiles and ensuring tax structures demonstrate sufficient substance.[6] The CRA’s scrutiny of tax structures is not limited only to large multinational enterprises.

Potential Traps

Transfer pricing penalties are intended to be a compliance penalty focusing the efforts made by taxpayers to accurately determine arm’s length prices or allocations. Taxpayers should be aware of the Penalty Threshold as it applies to their circumstances, respect the contemporaneous documentation requirements and ensure that “reasonable efforts” are made.

Failure to prepare contemporaneous documentation

The assessment period for transactions with non-arm's-length non-resident persons is extended by three years after the taxation year is initially assessed (for a total of six years for a CCPC, seven otherwise).[7] At any time during this period, the CRA can send the taxpayer a demand under paragraph 247(4)(c) to provide contemporaneous documentation.

If this documentation is not provided to the CRA within three months, the taxpayer will be automatically deemed not to have made reasonable efforts. Since subsection 247(3) does not permit any reduction of the penalty, the penalty will apply automatically if the CRA’s adjustment exceeds the taxpayer’s Penalty Threshold.  

T106 information returns

The T106 is an annual information return where taxpayers report non-arm’s length transactions with non-residents. Taxpayers are required to report on the T106 whether they have prepared contemporaneous documentation and list the transfer pricing methods used. The CRA screens files for audit based on T106 information. Thus, T106’s that are not properly prepared may attract unwanted CRA attention.

Taxpayers are required to file a T106 if the combined dollar value of intercompany transactions is greater than $1 million. However, a transfer pricing penalty could be applied even if the taxpayer’s intercompany transactions are lower than this de minimis exception

Penalties even if no revenue

The issue of penalties could become problematic for taxpayers in capital intensive industries or for small or start-up companies. As the Penalty Threshold is based on a de minimis amount, taxpayers with no or minimal revenues have far less room for error in setting their transfer prices. Additionally, subsection 247(9) prevents taxpayers from artificially increasing gross revenues to get under the Penalty Threshold.

Penalties despite no additional tax payable

Subsection 247(3) applies to the full amount of an adjustment for a taxation year, rather than to any increase in taxable income or tax payable. As a result, a transfer pricing penalty may be imposed even if the adjustment under subsection 247(2) does not result in any additional tax payable (e.g., due to the availability of losses or deductions).

No relief from penalties under MAP

Due to the nature of transfer pricing disputes, taxpayers often turn to the Competent Authority Process, found in the Mutual Agreement Procedure (“MAP”) article contained in some of Canada's tax treaties, to seek relief from double taxation after an adjustment.

However, the application of transfer pricing penalties is not covered by the MAP. Under subsection 247(11), the normal provisions to challenge a Part I assessment apply to subsection 247(3) penalties.

Taxpayers electing to pursue the Competent Authority Process should file a notice of objection and request that the CRA Appeals Branch hold it in abeyance until the issue is resolved by the competent authorities.

Penalties can be imposed for “statute-barred” years

The CRA recently took the view that an adjustment under subsection 247(2) can be made at any time, irrespective of whether the underlying transaction occurred in a statute-barred year. Furthermore, in the CRA's view, a penalty under subsection 247(3) can also be imposed at any time, even in respect of a statute-barred year.[8]

Conclusion

Taxpayers must make reasonable efforts to set and document arm's length terms and conditions regardless of the size of their intercompany transactions. Typically, guarantee fees, transactions involving intangible assets, restructurings shifting profits to low-tax jurisdictions and insufficient documentation attract audit scrutiny. The calculation of penalties is the same no matter how significant the adjustment (providing the adjustment exceeds the taxpayer’s Penalty Threshold).

Taxpayers must be proactive in preparing proper documentation in order to help avoid the application of penalties, and should take additional steps to ensure that reasonable efforts have been made. 

Invitation for Discussion:

If you would like to discuss this article in greater detail, or any other transfer pricing or tax law matter, please do not hesitate to contact Rami Pandher in the tax group at Nerland Lindsey LLP.

Disclaimer:

Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.

[1] For example, the Penalty Threshold for a taxpayer with gross revenues of $500,000 would be $50,000. In other words, if an adjustment under subsection 247(2) exceeds $50,000, the taxpayer could be subject to a transfer pricing penalty.

[2] For more information on “reasonable efforts” see: Colborne, McLaren, and Barbour, “Subsection 247(3): What Are Reasonable Efforts?” (2016) 64:1 Canadian Tax Journal 229-43.

[3]Access to Information Act disclosure – see the notes to subsection 247(2) in David Sherman, The Practitioner's Income Tax Act, 51 ed (Toronto: Carswell, 2017).

[4] Note that in Alberta Printed Circuits Ltd. v The Queen, 2011 TCC 232, the issue of penalties was conceded by the taxpayer (paragraphs 6 and 247).

[5]Marzen, at paragraph 216.

[6] Key transfer pricing cases include: Canada v GlaxoSmithKline Inc., 2012 SCC 52; Canada v General Electric Capital Canada Inc., 2009 TCC 563, aff'd 2010 FCA 344; and McKesson Canada Corporation v The Queen, 2013 TCC 404.

[7] Subparagraph 152(4)(b)(iii) of the Tax Act.

[8]CRA Document No. 2016-0631631I7, “Transfer pricing capital adjustment”, dated September 14, 2016.

Related Insights

  • Canadian Companies Need to Assess Their “Foreign Private Issuer” Status for SEC Reporting Purposes
  • CSA Staff Says Most Coin/Token Offerings Are Securities
  • Letter of Credit Security and the “Autonomy Principle”
  • OSC Provides Guidance on Hostile Take-Over Bids
  • Trust Residency Post-Fundy
  • Coming Soon – Mandatory Privacy Breach Reporting and Record-Keeping
  • A Reminder for D&O’s re: Civil Liability for Secondary Market Disclosure
  • Canadian Disclosure Requirements for US Marijuana Issuers