A new look at risk characterization

Andre: Hello, everyone, and welcome to our webinar, A New Look at Risk Characterization. My name is Andre Bergeron. I'm a partner with Gowling WLG. I've been here for a year now and my practice focuses on transfer pricing analysis, mutual agreement procedures and advanced pricing arrangements. Prior to joining Gowling WLG I was an economist with the CRA's Competent Authority Services Division, working on advanced pricing arrangements, mutual agreement procedures, various international audits, specifically with the lens of doing economic analysis and conducting optional analysis profiles and determining an appropriate rate of return for companies and negotiating these results with the other competent authorities. I'm joined here today by my colleague, Pierre Alary, who will introduce himself.

Pierre: Thank you, Andre, and thank you, everyone, for joining us today. My name is Pierre Alary and I'm a lawyer and partner in the Gowling's Transfer Pricing group. I have been with Gowling for 14 years and my practice focuses primarily on transfer pricing and tax dispute resolution. As Andre just mentioned, the Gowling's Transfer Pricing group deals with all aspects of transfer pricing in the Canadian market. Whether that means preparing contemporaneous documentation for our clients or assisting them in their dealings with the Canada Revenue Agency. Whether during an audit, by way of a mutual agreement procedure, an advance pricing arrangement or through an objection or appeal before the Tax Court of Canada. Some of you, or your clients, may have experienced dealing with the Canada Revenue Agency, which we may refer to during this presentation as the CRA. The CRA has been one of the leading tax administrations over the last 25 years when it comes to transfer pricing but they are generally viewed as one of the most aggressive tax administrations in the world. Canada is often referred to as a subsidiary country and most of our clients are in fact subsidiaries of foreign parents in large multi-national enterprises. Because of these dynamics taxpayers in Canada are likely at higher risk of being subject to a CRA audit than taxpayers in most other countries. As you know, when it comes to determining and documenting your transfer pricing, your analysis will examine the functions, assets and risks of the relevant parties. While a heavy emphasis is generally placed on the functions of the parties, the events of the last few years have generated a greater need to focus on the risks assumed by the parties, and that is why we want to speak to you today about risk characterization.

Now I will pass things over to Andre for the remainder of this presentation. Andre, as your group's economist, is uniquely qualified to speak on the subject after having left the Canada Revenue Agency to join our group just over a year ago during this COVID-19 pandemic. That being said, I will be monitoring the chat, so please don't hesitate to use the chat function to send us any questions you may have about today's subject or about transfer pricing in Canada, in general. We will do our best to answer all your questions before the end of the webinar or we can connect with you afterwards. With that, I'll pass things back over to Andre for a deep dive on risk characterization.

Andre: Thank you, Pierre. Today we plan on talking about risk characterization. So basically I've divided the webinar into two distinct components. The first one is really risk characterization itself. So we'll briefly talk about risk considerations pre-COVID-19 and how I would structure or look at risk, on a general basis, in the documentation that we'd be preparing. Then we'll talk about recent events and their impacts on multi-national enterprises, specifically considering these risk factors I mentioned in Part 1. In Part 2 then we're going to look at the transfer pricing considerations and how various tax authorities are going to look at changes that have happened over the past two and a half years. So TP considerations in light of recent events and tax authority analysis and mitigation strategies on how we can address questions that would come from our tax authorities in our jurisdictions.

So the OECD statement on risk analysis. I won't go through the details but bottom line is in section 1.52, the OECD guidelines state the importance of proper risk analysis in transfer pricing. This isn't surprising because we're always looking at the functional analysis of the function assets and risks with regards to determining the appropriate price for transactions within a multi-national enterprise. The OECD guidelines, the new issue from January 2022, reiterate that but the bottom line is the level assumption of risk is therefore dependent on economically irrelevant characteristics that can be significant in determining the outcome of a transfer price analysis. The Canada Revenue Agency, similar to many tax authorities worldwide, requires a thorough risk analysis as part of an functional analysis. In Canada section 247 of the Income Tax Act will legislate TP requirements and specifically section 4 will outline the shopping list of information you have to consider in contemporaneous documentation.

The risk analysis in the documentation. Normally what I look at are these elements of risk in any of the documentation that I've put forward. So product risk, market risk, inventory risk, start-up risk, credit risk and foreign exchange risk. The level of effort that I will be inputting into the document will obviously be determined by the type of transaction I'm looking at. So if I'm looking at an inter-company loan obviously I'm going to focus a lot more on the credit risk as the credit risk profile will ultimately determine the interest rate, etcetera. Whereas if I'm talking about a distribution entity then I'd probably be looking more at the product risk. Who's going to be assuming the product risk if there's an issue down the line once you sell the product. And, finally with regard to market risk, then I'd look at what are the various impacts if there's a market collapse in the particular industry and who will assume those risks.

Prior to March 2020, and I'll caveat this right off the bat, from 2010 to 2019, in North America anyway, there's a period of relative economic stability. So after the great recession of 2008 and 2009, when the markets collapsed and there was an adjustment there, I remember looking at some of the comparable throughout the period, particularly in the auto industry in North America, and noticing there were a lot of variances in how companies reacted or were impacted by this crisis. But since 2010, in North America, there was relative stability there. So the reports were prepared, focused on functions conducted and assets contributed, because to some degree unless you went very far back you couldn't really measure the risks. The analysis of risk and the ability to manage exposure to risk was really hypothetical in nature and discussed in theory. Benchmarking analysis in comparable sets reflected this relative stability. As I say that I recognize that it's not the case for all regions. Between 2010 and 2019 there were various events worldwide that had impact on various countries and various regions. In Japan you had the tsunami that had an impact on manufacturing in that country and for all the multi-nationals that are headquartered there. In Europe you had the credit crisis in the mid-2010s and that had an impact on companies there as there was a risk of default. I don't want to say there's nothing that happened between 2010 and 2019, but I know from a North American perspective, there was a relative stability that we could work with and at least it reflected itself in the comparable.

So the first event I want to talk to you about, and I think there's no surprise here, is obviously the pandemic. So in March 2020 the COVID-19-19 pandemic was declared and immediate lockdown impacts were felt differently in different segments. So on the one hand you had stores that were closed, worldwide, and then a lot of those businesses had to adapt and move online. Some other businesses actually benefited from this model as you have a change in logistics and product flows and transportation. The services industry largely moved to a work from home model. If you did not have to go to the office then you could stay home and work from there. Crude oil prices dropped significantly as demand for oil and gasoline plummeted worldwide and then manufacturing was briefly impacted as what looked like a short term lockdown ended up converting itself long term. But from a short term perspective, manufacturing entities were also sometimes looped into the general lockdown. Industries were impacted in different ways. Travel and Tourism were obviously negatively impacted by restrictions on movement. This obviously included airlines, hotels, restauration, which on the restaurant side had an impact down the line on the agricultural segment and how food was packaged and distributed. Other industries benefited so you wouldn't be surprised if I talk about pharmaceuticals, healthcare and building supplies reaped the benefits. Building supplies, I know a few companies when you look at them from a comparability perspective, they had significantly increased as people could not travel anymore so they started working on renovating various parts of their homes, because they were stuck there. So some industries did benefit from the pandemic.

The government relief measures was the next big shock, I guess, you could talk about in recent events. So immediately after the pandemic began governments worldwide enacted measures to help individuals and companies. In Canada we had two specific sets of measures that were put in place. The first one really looked at companies and supporting companies as they were navigating through these changes. So that was the Canada Emergency Wage Subsidy which helped employers affected by the pandemic. The second one was really more of a laid off or employee at home and how to support them. A bit of an employment insurance. So the Canada Emergency Response Benefit provided income supports specifically to employed and self-employed individuals. Needless to say there were millions that were spent on both these programs. As the CEWS was a direct subsidy to business the CRA stated that it expects subsidies will not be netted from a transfer pricing perspective. So we'll touch on that a little bit later as to what that entail but obviously this is worldwide. This was an issue that needs to be looked at as different entities potentially receive these subsidies from the government.

So lockdown has brought obviously remote work. But remote work has its own aspects from a risk perspective that need to be considered. As public health and social distancing measures implemented during the pandemic required jobs that could be performed remotely, be done from home, and companies have adapted to and introduced fully remote or hybrid models, leaving behind office spaces and creating opportunities to relocate. That's really where the crux of the risk comes into play. So individuals could work in the same city or opt to be in a different region or country. For example, in Canada there was talk about housing prices in other regions just went up incredibly. So in the Atlantic Provinces, for example, a lot of people that are working in Toronto were looking at moving out back East and that was creating pressure on housing prices in those regions. But in that case we're talking about being in the same country. So what if you're in a situation where you could be working in Europe in one of the smaller countries there and you could move to another country. How does that impact the risk allocation between those countries if you start working in a different jurisdiction? So as risk allocation is closely linked to the individuals who manage and mitigate risk, their location is key from a transfer pricing perspective, as the value and the profits or the losses could follow to these individuals to these jurisdictions. So it's one thing if you have a developer moving from Canada to the US and doing the work in the US. What happens when you've got actual decision makers that are opting to work in other jurisdictions? We have a file at the moment that we're working one where the executive committee of the company, there are often some changes as to which location, which country, they're in and that's changing the allocation of those costs related to that employee.

The next big event was the microchip shortage. So as the pandemic unfolded areas that were already exposed to potential shortages were pushed to the limit. Microchips were already in strong demand prior to the pandemic, mostly for manufacturing in vehicles and in laptops, etcetera, but the pandemic worsened the situation. So the increased demand for laptops and tablets to work remotely was obviously straining the system, and then companies started stockpiling and ordering them in advance which put extra pressure on manufacturers to produce, and then those that did were not in line to obviously order these products ahead of time ended up getting the short end of the stick there. On top of that there was, some of the articles I have read spoke to the winter storm in Texas, which impacted some of the microchip manufacturers there, and then there was a fire in one of the plants in Japan. So when you've got this limited set of manufacturers of these products, and you've got an impact on a manufacturer on top of an already worsening shortage worldwide, then that obviously doesn't help the situation. Toyota, Ford, Apple and Sony slowed or halted production due to these shortages and others have followed suit. But this has had an impact and a ripple effect down the line. So manufacturers are still significantly impacted by these shortages and are cutting production. We obviously hear this news on a regular basis.

The next aspect is the supply chain. So there have been major supply disruptions and changes. Companies have had to adapt and restructure their supply chains to be flexible in the event of supplier disruptions or shipping delays. One of the articles I was reviewing was talking about the cost of shipping containers is increasing significantly since March 2020 and same with air freight fees worldwide. While most goods are obviously on shipping containers, because that's the most efficient way and cost effective way of shipping goods, products like phones and tablets are shipped via air. Any time sensitive product for the market would be shipped by air. Labour shortages in the trucking industry meant freight would stay in ports. This was particularly, there was a truck driver shortage in Europe, and then North America increased pressure on railroads, created some issues there as products were being held up in ports because there wasn't enough supply on the railroads. Then you add to that the Ever Given container ship that blocked the Suez Canal and we all remember reading about that. That definitely stressed the global supply chain. Anyone who followed that story, you may remember seeing aerial pictures of the amount of ships waiting to enter the Canal, prior to and then afterwards. If you think that there's a crucial part on one of those ships, and you're waiting on that to manufacture, that has further delays down the

line. Again, other references to China's zero COVID-19 policy. You don't have the work force in some of the major shipping ports. If you're impacted from that perspective also, then you're slowing down some of the major ports that are moving out manufactured materials from China. Manufacturers and distributors have had to adjust quickly to avoid delays and resulting in extra costs in receiving and shipping goods.

Finally, all this has led to inflation, and inflation has been one of the big talks over the past six months as countries worldwide have had to grapple with the effects of rising consumer demand coming out of the pandemic, and that's colliding with continued supply shortages and transport issues. Stimulus and government relief packages injected so much money into the economy that that's added extra pressure and support to this rising demand. Increased prices have been significantly impacted along the MNEs production and distribution chain, creating new risks for consideration there. Immediate action by central banks worldwide to curtail inflation by raising interest rates have also had an important impact on the various areas of the MNEs affairs. Now specifically costs of intercompany lending is going to rise and parent and subsidiary company credit risk profiles may change, which may require further analysis down the line.

In the next section we're going to talk about how these risk elements play into transfer pricing within a multi-national and how tax authorities would be looking at that moving forward. So how does this impact transfer pricing? There are many implicants for a multi-national enterprise. For a distributor of goods, storefront closures can result in inventory risk. So creating obsolesce of products and spoilage and credit risk for cash flow issues. Just think about a company that's not selling out of a location that has to pay rent. So how do they manage that from a cash flow perspective? If the distributor was receiving an operating margin pre-pandemic, will they continue to receive that margin and will the parent assume these risks? That's one of the first questions I would ask. For an R&D service provider the ability to work remotely may shift some of the product list. So questions could arise as to the location of the work being performed and where the ability to mitigate the risk would arise. So think of prior to the pandemic you had probably a team of developers in a room. who are all of sudden they're working remotely and depending on where the work can be done, could be scattered around in different jurisdictions. What happens with the creation, the value of the creation, but also the risk of a product defect?

There's also government assistance which raises questions regarding financial treatment of a subsidy. Which entity keep the subsidy for intergroup R&D and marketing services and how does this impact the cost plus if that's the methodology that's being adopted? On government assistance, for example, I know in Canada we specifically look at how an R&D company that receives subsidies would be treating this from a financial perspective and how that impacts the cost plus they would be receiving from the parent. For a manufacturer, the microchip shortage creates delays and shutdowns. Delays and shutdowns generate loss revenue and further extraordinary expenses to be recorded by the manufacturer, inventory can accumulate in the interim.

Supply chain disruptions have forced optimal global MNE structures to be reviewed and be revised. Sourcing of products by manufacturers and finished products by distributors may change and that requires a new approach to the transactions between MNE members as the supply chain is adapted to this new flexible model. Finally, inflation is increased into company financing risk remedy members as interest rates have increased. So credit risk profiles and arms length interest rates between members will be subject to external review.

What has the OECD said on treatment of these new risks and recent impacts due to COVID-19 and other aspects? So the OECD released a guidance on transfer pricing implications of the COVID-19-19 pandemic to help tax administrations and companies navigate this new risk environment. Of note, in terms of limited risk entities, the guidance says it would be necessary to consider specific facts and circumstances when determining whether a so-called limited risk entity could incur losses at arms length. If you're a distributor are you going to be incurring some of these losses will really depend on the situation at hand. In section 47 of this new guidance, in terms of exceptional and non-recurring operational costs, it's important to consider how these costs would be allocated between independent parties operating in comparable circumstances. Finally, in section 65 they talk about the terms and conditions of government assistance, and whether temporary or ongoing need to be considered, along with the impact on the MNE transactions in a transfer pricing analysis. The guidance itself also goes into various considerations for comparability analysis and impact on advance pricing arrangements from a go forward perspective. These are all interesting materials that you should take a look at in this guidance from the OECD. But the bottom line is, the key takeaway is, every transaction needs to be considered on its own to determine how related parties would have behaved.

What do tax authorities look for? Tax authorities worldwide will focus their attention on various aspects. What are the pre and post-COVID-19 terms of trade between the related parties? If a limited risk distributor was receiving the operating margin pre-COVID-19, is it still receiving such a return, and if not, why and what has changed? Take the example of a company throughout 2018, 2019, was declaring a 2%25 OM. No problem. 2020 comes around. All of sudden they're declaring losses and from a go forward perspective. What happened and what has changed in the limited risk distribution profile of the company that would warrant that? If we're talking about a contract manufacturer that was not exposed to excess inventory risk in the past, is it still sheltered from these risks? If there are changes the documentation should demonstrate why these changes occurred.

What will tax authorities look for with regards to government subsidies and who benefits from these? So prior to the pandemic incentive programs were generally targeted in nature. I know in Canada one of the programs that we have that's generated a lot of discussion has been subsidies from Provincial Governments and Federal Governments, directly subsiding wages in video game development. The impact of the government's subsidies is already a hot topic here, from a transfer pricing perspective, and it always comes down to who benefits from subsidy and how should it be treated from a TP perspective? Does the subsidiary keep the government subsidy or does it go back to the parent? The general widespread use of government subsidies has increased this discussion as many companies have benefited from these wage subsidies. In Canada, specifically, with the Canada Emergency Wage Subsidy. So how are tax authorities going to look at this? Well they may consider how the subsidiary would support the business, and whether on wages to support services offered, or on prices for the products that are manufactured. But bottom line is it's determining which entity benefits. In Canada we have a transfer pricing memorandum, TPM 17 we call it, which specifically states that unless you can prove the circumstances warranted normally the entity in Canada will keep the subsidy and the company in the US will still provide a cost plus mark-up on the services done in Canada. We've seen that applied in the R&D segment.

Next up is in a remote work model, where are the profit drivers and risk mitigation measures located. A lot of our tax system is based on the location and in a pre-COVID-19 environment employees are generally expected to be onsite. If the company was located in a specific city the employees were coming to that location to work. But in a remote work environment how do you determine the jurisdiction of work? A key decision making functions migrating with the remote work. So tax authorities will probably review whether or not profit and risk has shifted with workforce migration and documentation in terms of employment may need to be reviewed by the MNE to ensure that the appropriate functions, assets and risks are delineated in any of the work agreements with their employees.

Who bears the extraordinary costs related to personal protective equipment and shortages and supply chain issues? I'll give you two examples here. The first one is many of the manufacturing companies that we work with have put in place a series of COVID-19 screen protocols where as employees enter the site, they have to test, they have to put on equipment in order to assess the manufacturing facility. In other circumstances we know that supply chain issues and microchip shortages have created significant backlog in manufacturing. For example, in a recent regulatory filing, General Motors stated that they manufactured 95,000 trucks in the second quarter of 2022 and put them in storage waiting for microchips. So what is the cost of this delay and the extra step in manufacturing and who will ultimately bear the cost of this? Non-reoccurring and extraordinary items have been incurred by companies worldwide to keep processes moving throughout the pandemic. So GM, in this case, opted to continue manufacturing, put the vehicles aside while they await for microchips, but they're going to have to pay the extra step of having people put those microchips in, once they come in. Efforts to track these costs will help determine the entity which should bear these costs. Tax authorities may review ultimately what the pre and post-COVID-19 scenarios were to determine if the costs would have been incurred by the entity in normal circumstances. So really, as you determine what is extraordinary costs are related to, then you would breakdown this on the functional analysis and the characterization of an entity. Who should be bearing them long term and how does this impact the transfer pricing?

Finally, how have interest rates changed the financial relationship between MNEs? So the increased pressure on cashflow for companies, that's they assume the extraordinary short term costs related to the pandemic, and financing to ensure sufficient cashflow is a key consideration that needs to be looked at. Credit risk profiles may have changed due to the specific industry exposure in the pandemic, impacting third party rates available to entities. So you're in an industry that's suffered hard through the pandemic and on top of that you're having financial issues, then potentially the company's credit rating is going to reduce, increasing potential rates that you have to pay. Finally, interest rates on intercompany loans may fall outside the realm of interest rates available for that credit risk rating.

What are tax authorities going to look at? They might look at the financing arrangements of the entity. So if a loan was incurred to assume extraordinary expenses that usually would have been taken on by the parent then would the interest rate be allowed? Potentially not. They might also look at the intercompany loan on a yearly perspective. They'll look at the yearly test of the credit risk rating and then verify whether or not a better interest rate would have been available to the subsidiary or to the borrower that's looking at the funds. This has been an issue that we've been working on significantly with various companies here at Gowling because the Canada Revenue Agency's been looking at many of these loans and requesting a yearly test, particularly as interest rates have dropped from 2010 to 2019, and then they will work with the interest rate drop in 2020/21 and then the interest rates increasing in 2022, is obviously a question that we're going to see later as we progress in time.

To conclude, the sequence of world events over the past years have created shockwaves in risk characterization with significant impact on transfer pricing. It's important that MNEs take a fresh look at their documentation on a yearly basis to identify how they have managed risk within the MNE. Changes in risk characterization between the pre and post-COVID-19 periods need to be clearly delineated with a thorough functional analysis to support that characterization. My assumption is that tax authorities are going to lean towards a constant and consistent approach from the pre and post-COVID-19 periods, and specifically target changes resulting in losses or transfer of profit or risk to other jurisdictions. From an intercompany loan perspective I suspect tax authorities are going to start requesting a yearly test to ensure interest rates are arms length.

That concludes our presentation. I want to thank all of you for tuning in today to hear our views on risk characterization and how tax authorities may be looking at how your clients or companies are looking at transfer pricing in this new environment. If you have any other questions or want to reach out, do not hesitate to contact Pierre or myself. Finally, thank you again to Pride Partners International for inviting us to speak today.