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Transfer pricing refers to the prices charged for goods and services and the use of property (including intangible property) to or by a non-resident related party. Canada's transfer pricing rules are found in section 247 of the Act. Many other countries, including the US, have similar transfer pricing rules in their domestic tax law.


The transfer pricing rules embody the arm's length principle, which is endorsed by the Organization for Economic Co-operation and Development (OECD). This principle requires taxpayers to determine their income tax consequences in respect of virtually all transactions with non-arm's length parties based on arm's length terms and conditions. The rules are intended to prevent multinational corporations from shifting profits out of Canada by charging prices for intra-group transfers of property, or use of property and provision of services that deviate from arm's length prices.


The transfer pricing rules apply where a taxpayer (or a partnership) and a non-resident person with whom the taxpayer (or partnership, or a member of the partnership) does not deal at arm's length, are participants in a transaction or a series of transactions, and:


1. the terms and conditions made or imposed in respect of the transaction or series between any of the participants in the transaction or series, differ from those that would have been made between persons dealing at arm's length; or


2. the transaction or series would not have been entered into between persons dealing at arm's length, and can reasonably be considered not to have been entered into primarily for bona fide purposes, other than to obtain a tax benefit.


If the transfer rules apply, the Act provides a recharacterization so that:


a. in the case of the first condition, the transaction or series is deemed to occur under terms and conditions that would have been entered into between arm's length parties; and


b. in the case of the second condition, the transaction or series is deemed to be a transaction or series that would have been entered into between arm's length parties.


In addition to the adjustments to arm's length prices, a taxpayer will be subject to a penalty under subsection 247(3) of the Act where the deviation from arm's length amounts is greater than CDN$5 million, or 10 percent of the taxpayer's gross revenue for the year, whichever is less. The penalty is essentially equal to 10 percent of the adjustment to the arm's length amounts.


Generally, a taxpayer will avoid the penalty where the taxpayer, or the partnership of which the taxpayer is a member, makes a reasonable effort to determine and use arm's length prices or allocations. The taxpayer or the partnership is deemed not to have made a reasonable effort to determine and use arm's length transfer prices or allocations in respect of a transaction or series, unless the taxpayer or the partnership complies with certain requirements to maintain contemporaneous transfer pricing reports to support the determination of arm's length prices and allocations.


In addition, generally, the Canadian corporation will be deemed to have paid a dividend to the non-resident person equal to the amount of the transfer pricing adjustment and this will result in non-resident withholding tax. The deemed dividend will not arise if the non-resident person is a controlled foreign affiliate of the Canadian corporation. It should be noted that in certain situations, the deemed dividend can be reduced or eliminated if the amount paid to the non-resident person is repatriated to the Canadian resident.


A large part of determining the appropriate arm's length prices and preparing contemporaneous documentation is identifying comparable arm's length transactions and obtaining relevant information about such transactions. The OECD's Transfer Pricing Guidelines for Multinational  Enterprises  and Tax Administrations (the OECD Guidelines) outline a number of factors which may influence the degree of comparability of the transactions in question. These factors include:


1. the characteristics of the property or service being purchased or sold;


2. the functions performed by the parties to the transactions;


3. the terms and conditions of the contract;


4. the economic circumstances of the parties; and


5. the business strategies pursued by the parties.


Over the years, various methods have been accepted by tax authorities in determining whether the prices or other amounts used by the taxpayer are arm's length amounts. The methods are divided two groups: the traditional transaction method and the transactional profit method. The traditional transaction method includes the comparable uncontrolled price (CUP) method, the resale price method and the cost-plus method. The transactional profit method includes the profit-split method and the transactional net-margin method (TNMM). The Canada Revenue Agency (CRA), the federal agency that administers the income tax law for the Government of Canada and most provinces and territories_,generally follows the OECD Guidelines in this regard. (See Information  Circular, IC 87-2R, entitled "International Transfer Pricing," dated September 27, 1999 (http://www.cra-arc.gc.ca/menu/ ICSC-e.html), as amended by CRA Transfer Pricing Memorand TPM-14 (http:/www.cra-arc.gc.ca/tx/nnrsdnts/cmmn/trns/) and TPM-15 in which the CRA provides its views on transfer pricing).


It should be noted that a transfer pricing dispute involving a corporation which is resident in a country which Canada has entered into a tax treaty, and which is entitled to the benefits of such treaty, may be settled by the Competent Authorities of Canada and the treaty jurisdiction, as set out in the mutual agreement procedure provision of the relevant tax treaty. Alternatively, a taxpayer can appeal a CRA transfer pricing determination to the Tax Court of Canada (TCC) and if unsuccessful at the TCC to the Federal Court of Appeal, and then with leave to the Supreme Court of Canada.



Foreign affiliate dumping rules


The Act targets Canadian resident corporations that are controlled by non Canadian corporations if the Canadian corporation makes an investment in another Canadian corporation (the"target"), and the value of the foreign corporations owned by the target exceeds 75 percent of the value of all properties owned by the target.The rules are very complex and may apply to many acquisition scenarios. For example, these rules may apply in a situation involving a non-resident corporation acquiring (directly or indirectly) the shares of a Canadian corporation which in turn owns one or more non-resident corporations if the value test is met.The effect of the rules is either a deemed dividend to the non-resident parent of the Canadian corporation which would be subject to Canadian non-resident withholding tax or a reduction in the paid-up capital of the shares of the Canadian corporation. It should be noted that in certain situations, proper planning can mitigate the adverse tax consequences of these rules.


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