A long time ago, in a galaxy far, far away … the tax system was less complex and simpler. However, in recent years tax laws have become extremely complex and tax authorities around the world have become much more aggressive. Being prepared to deal with an international tax audit and having a strategy to deal with tax authorities is a must.
International tax issues and in particular transfer pricing, is often cited as the number one concern of businesses operating beyond their home border. This concern is well founded when we see the efforts of the OECD implementing new or, as many governments like to say, "clarifying" rules around transfer pricing, the hiring of many new international auditors, a substantive increase in international audits, and the explosion in the growth of transfer pricing penalties being assessed. In this environment taxpayers, and in particular companies operating across international borders, must think strategically in their dealings with tax authorities.
While this article focuses on practical considerations for resolving transfer pricing matters with the Canada Revenue Agency ("CRA"), many of the comments apply equally to dealing with other tax authorities and other international tax matters.
Preparing a defence to a transfer pricing audit goes well beyond simply understanding the law, which in Canada is essentially comprised of one section - Income Tax Act (Canada) ("ITA") s. 247, and reading policy documents relating to the rules around transfer pricing issues. Many taxpayers and accountants are surprised to learn that the CRA's written policies often differ from the actual practices of CRA auditors. Take for example paragraph 51 of Information Circular 87-2R, which recommends that multiple year data be considered, whereas anyone who has dealt with a CRA audit knows that the CRA almost always looks at comparable data on a year by year basis.
In many cases CRA auditors misunderstand a taxpayer's business and the information provided can lead to inappropriate conclusions if it is not communicated effectively. Always keep in mind that the CRA auditor is not your friend and is not there to help you in any way. CRA auditors are employed to find tax adjustments and have a variety of powers at their disposal to get your enterprise's financial information. While non-privileged financial information should not be withheld, generally speaking it should only be provided when requested. Providing information that was not requested may lengthen the audit process or prompt unnecessary questions.
Every audit should be approached strategically, with each situation requiring a specific approach. While the start of most audits is generally similar, i.e. a request by the CRA for information and the subsequent provision of information, understanding the potential impact on the auditor's views of the information being provided will help in framing all responses. In this respect important questions such as: should I have a meeting to explain the rationale for the intercompany pricing?; or is the information easily understood in the transfer pricing report?; must be considered. Just because you may believe the intercompany transactions are reasonable and well explained does not mean that a CRA auditor with little understanding about your business will agree. A common issue that members of the Gowling WLG tax dispute resolution team face is educating CRA auditors about the business under audit and the reasons for various business decisions. CRA auditors are inherently skeptical and need clear and reasonable explanations for anything that may be outside the expected norms, such as why is it reasonable for a subsidiary to report losses while its parent reports a profit. There are in fact many reasons this can occur, but may be outside of what the CRA auditor would expect.
The Gowling WLG transfer pricing group has successfully defended many of its clients in tax matters by approaching each audit in a strategic and principled manner. This includes simply providing the business rationale and economic support for the intercompany transactions in a manner that is better understood by tax auditors. Working with our clients and the CRA, we explain the business reasons that business decisions were made involving the intercompany transactions and why the prices used were reasonable and result in arm's length pricing. CRA auditors can't be expected to agree with taxpayer positions if they have to make assumptions about facts or the information provided is not supported in economic theory. While agreement between auditors and taxpayers is sometimes difficult, it is made much easier when facts and analysis of transactions are presented in a clear and principled manner with multiple supporting arguments.
We will now discuss some specific strategies/considerations in dealing with transfer pricing audits.
Tax authorities around the world are limited by their domestic laws as well as bilateral tax treaties in the amount of time they have to review international transactions. In Canada, the ITA provides that the CRA has seven years to audit most international transactions including transfer pricing. However, this time period is often further limited by tax treaties. For instance, several of Canada's tax treaties restrict adjustments to related party transactions to six years.
These limitations must always be kept in mind when deciding whether to provide the CRA with a waiver extending domestic audit time limits. In some cases the CRA may misunderstand the time limitations of a treaty and request information for periods that cannot be adjusted. In such cases, it may be necessary to inform them of the audit time limitations or it may be in the benefit of the taxpayer to provide the information and wait until the end of the audit to advance arguments based on possibly expired audit rights.
Use of APAs
In situations where a taxpayer is dealing with repeated audits of the same issue or an ongoing lengthy audit, an Advance Pricing Arrangement ("APA") application is an option to consider. An APA is only applicable to years not under audit, but of strategic importance is that in Canada the same people who will review the request for double tax relief once the original audit is completed (Competent Authority) will also review the APA application. Furthermore, an APA can provide penalty protection, once accepted, for years that have been filed, but are not under audit. The APA team is typically led by more senior, and potentially less biased, international analysts. Competent Authority analysts can provide a new voice in the process and may help obtain a more reasonable result and, at minimum, speed up the process of double tax relief for the years under audit and provide tax certainty for future APA years.
Access to Information Requests
Internal CRA discussions and records can be a valuable resource in preparing a defence against audit adjustments. Filing an Access to Information and Privacy request should be considered immediately following an audit reassessment. We have found that in a number of cases there is disagreement within the CRA and there may be information to support the taxpayer's position that the CRA has ignored. This information can help prepare a defence that will be taken to Competent Authority or Appeals.
Accept the CRA Adjustment?
In some cases it may be advantageous to accept the CRA proposal. For instance, we have seen in several cases where the CRA is auditing a couple of years that result in an audit assessment, but applying the CRA methodology to other "open", i.e. not statute barred, years results in downward adjustments. The CRA auditors often do not consider years outside their audit scope and may not recognize that in some cases the application of their methodology will result in an overall refund to the taxpayer once it gets applied to all open years. If this factor is present in your case it can also help to resolve the issue in Competent Authority or Appeals. Even if the CRA adjustment was not accepted during the audit this issue, if present, can help in reaching a favourable resolution in Competent Authority or Appeals.
Think Outside the Box
Thinking outside the box can be effective, instead of getting caught up in arguing facts and issues when no one, i.e. the CRA, is listening. In more than one case we have seen where the facts support a different conclusion than that being considered by the CRA. The CRA often has a different view of the facts and may not be persuaded by the usual factors. This is where we have to consider alternative factors and analysis in support of the intercompany pricing.
Outside the box issues to consider can be wide ranging and some examples include:
- In the case of an audited entity that is reporting lower than expected profits -
- check the pay structure for employees, are they above the norm for the industry, did they receive up-front payments for future results affecting current operating results;
- were there higher than normal profits reported in pre-audit or post-audit years that need to be taken into account, i.e. longer business cycle;
- is the related party to the transaction reporting losses and what is the magnitude of these losses, perhaps a sharing of losses is not unreasonable even where an entity is routine; and
- are there specific market or industry issues affecting the audited entity's operations?
Too many times we have seen transfer pricing reports or replies to audit queries that give textbook replies. Relying on a comparable set without detailed reasons for the use of the selected comparables selected will often lead to the CRA rejecting the comparables. In fact we have found that arguing about comparables is often a waste of time and can lead to deadlock. We find it more effective to examine other issues, such as business, market and industry issues, which can help lead to a discussion of what a reasonable set of comparables for the transaction looks like. Comparables are often controversial as they can "make or break" an audit adjustment or support the taxpayer's position and as such they must be carefully approached.
Given the proliferation of transfer pricing penalties in Canada, the penalty threshold amounts should be considered when negotiating the close of an audit. It is commonly understood that transfer pricing is much more art than science and coming up with a specific price for an intercompany exchange can be very difficult. It is more likely that a range of results (prices) will be determined and the range can be very wide. Where there is disagreement and the CRA proposes to issue a reassessment, negotiations should, where possible, try and keep the adjustments below the penalty thresholds of 10% of gross income and $5 million per tax year. While there are tax treaties in place to deal with double taxation on any assessments, there is no relief from transfer pricing penalties and such penalties are not deductible.
With a new US government promising to significantly reduce tax rates from 35% to 15%, we are likely to see more money flowing in the direction of the US, resulting in more CRA audits questioning intercompany transactions. Canada is largely viewed as the home to subsidiaries of large international parent companies and as such there is often an outflow of excess profits to parent corporations. Rightly or wrongly, this perception causes the CRA to be more diligent in its review of transfer pricing issues, to ensure the Canadian government retains what it considers to be its fair share of corporate profits. What is fair and reasonable is up for interpretation in each case, depending on many factors that affect business and industry. We believe implementing a strategic and planned approach to managing your audit issues will provide for a more efficient process, resulting in the most favourable possible resolution.