Canada's federal tax authority, the Canada Revenue Agency (CRA) is a mature and sophisticated tax authority by any measurable global standard. With approximately 40,000 employees, the CRA is responsible for the administration of tax laws in Canada for most of Canada's 10 provinces and three territories, as well as for the operation of various social benefit programs and certain targeted incentive programs. One of the CRA's most important functions is the promotion of voluntary compliance through its enforcement program, which includes the conduct of tax audits. Transfer pricing audits are likely the most sophisticated types of audits carried out by the CRA.
The CRA started carrying out transfer pricing audits in a systematic fashion in the early 1990s. The International Tax Directorate of Revenue Canada, as the CRA was previously known, was formed in 1991 and international audit sections were built up shortly thereafter in the large tax service offices in major cities. The CRA currently employs well over 300 international auditors, with central support now provided by the International and Large Business Directorate (which also directs the activities of the CRA's aggressive tax planning and large file audit programs).
In the early years, the CRA's international auditors focused on fairly routine cross-border transactions such as the payment of management fees (administrative intragroup services charges, engineering and technical services), and transactions such as straightforward tangible property transfers (sale of inventory for distribution). The most common audit scenario was that of a Canadian subsidiary that received head office service charges from a U.S. multinational parent company. The CRA's international auditors were guided by the provisions of Section 247 of the Canadian Income Tax Act (and its precursor) as well as the CRA's Information Circular 87-2R, International Transfer Pricing (which came into effect in 1999). Screening of businesses for a transfer pricing audit was facilitated by the requirement that taxpayers file Form T106, Information Return of Non-Arm's Length Transactions with Non-Residents, in which they report (among other information) the amounts and types of transactions conducted with non-arm's-length nonresidents.
Over the last 15 years, the CRA has become increasingly sophisticated in its approach to carrying out transfer pricing audits. This is partly a result of initiatives carried out by other tax authorities around the world (the CRA is an active participant in many multilateral tax initiatives.) This sophistication also reflects the CRA's growing experience through the conduct of numerous transfer pricing audits and the related programs by its Competent Authority Services Division (advance pricing arrangements and mutual agreement procedures with other tax authorities). Some of the areas of increased focus are discussed below and include intangible property, financial transactions, and commodity trading issues.
The ability of foreign multinational enterprises to reduce profits in Canada through the charging of royalties for the use of intangible property (IP), especially trademarks and tradenames and the use of knowhow, has become an area of strong interest to the CRA. The CRA's general approach includes challenging the existence of any significant benefit from the use of IP, rather than disputing the determination of the quantum of such a benefit through the analysis of various royalty agreement database resources. Frequently, a taxpayer's transfer pricing documentation has focused on the mechanistic determination of a comparable uncontrolled price, rather than setting out and describing the benefit enjoyed by the Canadian taxpayer from such a royalty charge. The CRA would not accept general and broad statements about the benefits enjoyed by the recipients of royalty charges for IP. Rather, it would seek evidence of concrete advantages obtained, such as increased profitability, the exploitation of innovation demonstrated by increased sales and market share, or the increased productivity and cost advantages obtained. An additional CRA initiative has been its insistence on the unbundling of composite transactions and separate pricing and transfer pricing analyses of component transactions – most often the disentanglement of so-called "network intangibles" involving significant services as well as access to true IP.
The CRA also has become increasingly focused on auditing intercompany financial transactions, including loans, guarantees, and other credit arrangements involving significant financial charges. The CRA's economists (centralized in its Ottawa headquarters) are responsible for assisting its international auditors in the examination of cross-border financial arrangements within a multinational group. They are becoming increasingly sophisticated in the application of credit scoring techniques and the search for comparable loans and bonds. Most noteworthy, perhaps, is the CRA's application of the concept of implicit support in a well-known loan guarantee situation. More recently, the CRA has successfully attacked aggressive intercompany factoring arrangements and has considered concepts such as debt capacity and the economic characterization of credit arrangements.
A final example of the CRA's more sophisticated transfer pricing audit activity involves the analysis of commodity trading activities within a multinational group. The CRA has critically examined the characterization and situs of centralized commodity hedging operations and the appropriate treatment of gains and losses. These audits can result in the movement of hundreds of millions of dollars' worth of trading gains and losses and very large increases in Canadian tax assessments. Significantly, these audits often result in the imposition of substantial transfer pricing penalties under Canadian law, as there is no transfer pricing documentation in place to support cross-border transactions that the taxpayer did not previously even recognize.
Developments over the last few years, including the OECD's multifaceted base erosion and profit shifting (BEPS) initiative and several high-profile Canadian transfer pricing court cases, have further strengthened the sophistication of the CRA's transfer pricing audit program and approach. Strong intergovernmental coordination is frequently in place. The CRA is increasingly demanding large volumes of data and carrying out numerous interviews of operating personnel, arguably in situations when relevance is not apparent. There is a tendency for the CRA to ask very detailed questions about business relationships and to be increasingly skeptical about the benefits and even the economic value of common arrangements such as central service-providing entities within a multinational group. There is a focus on residual profit approaches, lost business opportunities, abusive termination of contracts, and a recasting of business relationships and transactions to suit the CRA's view of acceptable arm's length behavior. There is noticeable "trickle down" of BEPS initiatives and potential actions, even though the OECD's work is ongoing and Canadian adoption is still pending.
There is room for the CRA to develop its transfer pricing audit program further. The auditors are gaining experience and will continue to enhance their level of expertise through this experience, especially when non-routine transactions are encountered. Further, auditors are enhancing their knowledge and understanding of business practices and arrangements within large multinational enterprises. There is no doubt that taxpayers and their advisors will continue to face increasingly sophisticated challenges from the CRA's transfer pricing audit program.