Transfer Pricing Documentation Requirements

Michael Friedman, Partner

Todd A. Miller, Partner

Presented at:Federated Press – Basics of International Tax & Transfer Pricing

Metropolitan Hotel, Toronto, OntarioNovember 16, 2010

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Agenda

Contemporaneous Documentation: An Overview [Michael –5m]

Statutory Requirement for Contemporaneous Documentation [Todd – 10m]

Transfer Pricing Preparation Process [Michael 10-1m]

PATA Model Documentation Package [Todd – 5m]

Key Areas of CRA Review [Michael 15m]

Common Errors/Pitfalls [Todd – 15m]

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Contemporaneous Documentation: An OverviewWhat is “Contemporaneous Documentation”?Why do you need to create and maintain it?

Protection from penalties [to be discussed in more detail]

Management of tax risk (certainty/predictability – identify areas ofexposure (e.g., FIN-48 IDENTIFICATION OF APPROPRIATE RESERVE)

Basis for audit responses (makes audit processmuch more smoothly); CRA more likely to go away ifthey don’t smell blood in the water!

Inter-affiliate/global coordination

Strategic/Operational planning/Tax SavingsTAX PLANNING /OPTIMIZATION FUNCTION –eg. Contract Manufacturing Strategy, commissionairearrangement, moving IP offshore

Institutional memory

Facilitating future sale transactions

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Statutory Requirement for Contemporaneous Documentation

(i) History

Prior to the introduction of section 247 of the Income Tax Act (effective for tax years beginning after 1998) (Canada) (the “Act”), transfer pricing requirements were largely governed by former subsections 69(2)/(3) of the Act.

Brief overview of some of the cases in s. 69 and reasons for introducing new s. 247: Primarily, (i) to bring Canada in line with other MAJOR OECD Countries in formally recognizing arm’s length principle (as contained in the 1995 and 1996 OECD GUIDELINES) and (ii) PROVIDING FOR cd penalties IN RECOGNITION OF the importance of protecting the tax base (particularly based on international economic developments in the 80’s and 90’s (i.e. globalization))

Former subsections 69(2)/(3) Section 247

• “Reasonable amount in the circumstances” test -GLAXO, GE Capital, IRVING and other cases

• Informal documentation requirements (no hard timing deadlines, guidance)

• However CRA effectively applied these provisions by endorsing OECD Guidelines and required (per IC-87-2) a comprehensive intercompany pricing policy based on a thorough functional analysis; consistently rejected comparable profits method (CPM)

• Comparative “Arm’s Length” test for each inter-affiliate transaction

• 247(3) – Imposes transfer pricing penalties based on TP adjustments under 247(2) for years beginning after 1998

• 247(4) – Contemporaneous documentation requirement to avoid penalties (or at least minimize the likelihood of application)

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Statutory Requirement for Contemporaneous Documentation

(ii) Penalty Provision – Subsection 247(3) of the Act

Penalty of 10% of:

the total transfer pricing income and capital adjustments for the year

minusthe total transfer pricing income and capital adjustments and the total transfer pricing income and capital setoff adjustments relating to transactions in respect of which “reasonable efforts” have been made to determine and use arm’s length transfer prices (the “Penalty Base”)

Penalty applies in respect of the portion of the Penalty Base that exceedsthe lesser (A) of 10% of the taxpayer’s gross revenues (as defined in 248(1); subsection 247(9): transaction deemed not to have occurred if purpose was to increase not revenue; 247(5) attributes partnership revenue; 247(6) deals with tiered partnerships and (B) $5 million [THRESHOLD]

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Statutory Requirement for Contemporaneous Documentation(ii) Penalty Provision – Subsection 247(3) of the Act (cont’d)

CRA: The penalty imposed under subsection 247(3) is intended to be a compliance penalty (not mandatory).

If a taxpayer made reasonable efforts to use arm’s length transfer prices, the penalty will not apply.

CRA in TPM-09 (September, 2006): “A reasonable effort means the degree of effort that an independent and competent person engaged in the same line of business or endeavour would exercise under similar circumstances”. What is reasonable is based on what a reasonable business in the taxpayer’s circumstances would do, having regard to the complexity and importance of the transfer pricing issues that arise in the tax payer’s case

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Statutory Requirement for Contemporaneous Documentation

(iii) “Reasonable Efforts” Deeming Rule

Unless a taxpayer “makes” or “obtains” documentation (“records or documents”)containing the items listed in paragraph 247(4)(a) of the Act by the relevant “documentation-due date” (defined in section 247(1)), for the taxation year in which the transaction was entered into (filing due date in case of person, s. 229 due date in case of partnerships) the taxpayer is deemed not to have made reasonable efforts to determine and use arm’s length transfer prices.

Under subsection 247(4), the taxpayer must also:

update contemporaneous documentation for subsequent taxation years or fiscal periods to account for material changes; and

Provide contemporaneous documentation to the Minister of National Revenue within three months of a valid written request.

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Statutory Requirement for Contemporaneous Documentation

(iii) “Reasonable Efforts” Deeming Rule (cont’d)

Documentation must provide an accurate and complete description (in all material respects) of:

i. the property or services to which the subject transaction relates;ii. the terms and conditions of the transaction and their relationship, if any, to the terms and

conditions of each other transaction entered into between the same parties [what about other related parties?];

iii. the identity of the participants to the transaction and their relationship to each other at the time the transaction was entered into;

iv. the risks the participants assumed, the functions they performed and the property they used or contributed in respect of the transaction;

v. the data and methods considered and the analysis performed to determine the transfer prices, allocation of profits or losses or contributions to costs, as the case may be; and

vi. the assumptions, strategies and policies that influenced the determination of the transfer prices, allocation of profits or losses or contributions to costs, as the case may be.

CRA, per IC-87-2R and TPM-09, views the above items as the “basic framework” for documentation necessary to satisfy the “reasonable efforts” test; additional CRA expectations are set out in TPM -09 and IC-87-2R

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Statutory Requirement for Contemporaneous Documentation

(iii) “Reasonable Efforts” Deeming Rule (cont’d)

CRA: A taxpayer will be deemed not to have made reasonable efforts if contemporaneous documentation is not received within three months of the taxpayer’s receipt of a written request. (TPM05, Oct. 13/04: CRA tells auditors no extensions to this deadline because it is a statutory requirement; says however, to nevertheless accept late filed documentation for purpose of completing audit)CRA: The documentation list set out in paragraph 247(4)(a) is not exhaustive; compliance with the list does not preclude a finding that the taxpayer has not made reasonable efforts to determine arm’s length transfer prices or that such prices in fact meet the arm’s length standard. (i.e., penalties and adjustments could still apply)Part 7 of IC 87-2R as well as TPM-09 (September, 2006) sets out certain of the CRA’s expectation with respect to contemporaneous documentation practices. [see attached]

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Canadian Transfer Pricing Statistics

As suggested in private sector [source?] reports: The CRA has levied approximately $300 million in penalties pursuant to subsection 247(3) [since the rule was enacted?].

Failure on the part of the taxpayer to prepare contemporaneous documentation, or to provide documentation to the CRA within three months of a request, occurred in approximately 53% of the files that were subject to penalties pursuant to subsection 247(3). [does this mean complete lack of documentation or documentation that was considered to be of inferior quality?]

2007 auditor general report highlights

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Transfer Pricing Preparation Process

Accurately characterize and

describe the subject

transaction

Determine the most appropriate transfer pricing methodology

and the proper arm’s length transfer price

Identify the documentation requirements in each relevant

jurisdiction

Develop a documentation strategy/plan

noting any specific areas of risk/uncertainty

Assemble documentation providing full

support for the transfer pricing

approach

Establish a review process

to ensure timely, accurate

adjustments are made and

documented

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Transfer Pricing Documentation Preparation Process

Developing a Documentation Strategy:Description of the transaction

Define what type of product or service is being transferred/delivered and the terms of the transaction (consider breaking down by product, product line, transaction type, geographical)

Industry overview

Conduct analysis of industry-specific data and statistics (Explain your industry, how you operate globally and in each local market)

Functional Analysis

Describe the functions and risks associated with the transaction (Functions performed, risks assumed, property/assets deployed)

Determine the most appropriate transfer pricing methodology (with reference to hierarchy outlined in IC-87-2R)

Information Circular 87-2R provides an overview of methodologies

Explain which higher methods not relied on and why

Economic/Financial Analysis by product, product line, geographical)Consider comparable companies and/or transactions to identify appropriate pricing adjustments

Assess the financial results of the tested party

Provides financial data by which to evaluate the tested transaction

Identify where risk and exposures lie

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Sources of Data

Internal Sources

Past transfer pricing studies

Intercompany invoices, agreements, correspondence

Business plans and organizational charts showing the relationship between parties to the transaction

Functional analyses describing the functions and risks of each related party

Financial analyses documenting the economic circumstances associated with the transaction

Interviews with management

Foreign based information (financial statements,cost information, tax returns, etc.)

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Sources of Data

External SourcesCommercial /Public Databases (e.g. Sedar, Edgar, royaltynet)

Note potential lack of data specific to Canadian companies.

Be aware of differences in accounting systems when dealing with some international companies.

Industry Data / Standard Industry Practices

Trade Journals

Note that various characteristics can influence comparability among transactions. These include:

Contractual terms and conditions;

Descriptions of goods or services; and

Risks assumed and functions performed by the parties.

Other

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PATA Model Documentation PackagePacific Association of Tax Administrators (“PATA”) released a documentation package to help taxpayers meet the transfer pricing documentation requirements imposed by member nations. The package can be found at:

http://www.cra-arc.gc.ca/tx/nnrsdnts/cmmn/trns/pt-eng.pdf

Elements of the PATA documentation package include reports pertaining to:

Organizational structure;

Nature of the business;

Controlled transactions;

Assumptions, strategies and policies; and

Comparability, functional and risk analysis.

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Key Areas of CRA Review

CRA Standard Audit ProtocolRequests for contemporaneous documentation must be issued when conducting a transfer pricing audit. (TPM-05)

Requests for contemporaneous documentation can be issued by letter or query sheet. A sample audit query sheet can be found at:

http://www.cra-arc.gc.ca/tx/nnrsdnts/cmmn/trns/ppndxb-eng.pdf

Taxpayers must submit documentation within the three month period provided in subsection 247(4)(c) or they will be deemed to not to have made reasonable efforts to determine arm’s length transfer prices. (no exceptions)

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Key Areas of CRA ReviewCRA Transfer Pricing Red Flags

Persistent Losses/Profitability Variances

Comparison with industry

Particularly where low risk distributors or manufacturers are making chronic losses

Industry de jour

Intangibles and Royalties

difficult to value (lots of fluctuation)

In some cases very difficult to define or “pin down”

lack of comparability and corresponding royalty and license rates (consider royalty based on profits in such cases)

bundling – Tricky when have comp for one, not for other – do you work on residual basis?

Services and intangibles or products sold together (Bundling/Unbundling)

Business Reorganizations and Functional and Risk Profile of Group Members Changing (e.g. introduction of contract manufacturing arrangement), particularly where tax driven (e.g., transfer/sale/lease of tangible or intangible assets to non-resident entities; plant closure)

Management or Guarantee Fees (need to determine if management fee charge is justified and, if so, an appropriate allocation methodology (% of sales meet common) ) ; CRA and taxpayers may disagree regarding value of skills provided, CRA may try to limit deduction to specific expenses; in GE Capital, CRA argued that parent would provide guarantee for very little compensation (appears to be at odds with a-1 principle)

Transactions involving low tax jurisdictions (CRA can obtain from T106); offshoring of technology-CRA looking to impute royalties

Overlapping /Bundling Transactions (commissions, reimbursements)

T106 (checking no CD or change of TP methodology) (will most likely trigger audit of one TP methodology or the other)

Do U.S TPMs ignore valuable Canadian IP (view any intercompany transaction that is not favorable to the fisc. as being “abusive”)

Use of secret comparables and comparison with industry

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Common Errors/PitfallsInsufficient/incomplete contemporaneous documentation

Inappropriate use of comparables/methodologies

Failure to update contemporaneous documentation or employ a document maintenance strategy

T106 reporting errors – do you have CD – some people check no!

Failure to provide contemporaneous documentation within 3 months of request

No organizational agreements in writing – GET THOSE!

Documentation focusing on one entity (and failing to consider the resulting profits in other country; what conclusions would other tax administrations arrive at?)

No inter-affiliate/global coordination and overall strategy (Inconsistent positions (foreign based information that undermines the position you take))

Compromise of legal privilege – PROTOCOLS must be established

Lack of continuity of personnel (need for institutional memory)

Failure to appreciate differences between Canada specific requirementsand those in OECD and other countries) – for example, a US party mayhave TP documentation to the effect that a Canadian affiliated party is not paying LESSthan an arm’s length price for a particular product service; however, Canada would want to know that the Canadian party is not paying MORE for the particular product or service

Failure assess and understand how others will interpret the TP info you provide

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Consider a slide with concluding commentsUnderstand key benefits of CD preparation:

Tax PlanningRisk ManagementPenalty Exposure

Stay ahead – be proactive and prepared for an audit

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Transfer Pricing Documentation Requirements

Michael Friedman, Partnermichael.friedman@mcmillan.ca

d 416.865.7914 | f 416.865.7048

Todd A. Miller, Partnertodd.miller@mcmillan.ca

d 416.865.7058 | f 416.865.7048

McMillan LLP

181 Bay Street, Suite 4400

Toronto, ON M5J 2T3

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