Finance Canada proposes largest overhaul of Canadian transfer pricing legislative framework

In this blogpost, we will be discussing the proposed changes that the Department of Finance Canada intends to make to section 247 of the Income Tax Act. These modifications aim to address specific concerns in the existing legislation and bring Canada's transfer pricing rules in line with the current global agreement.

The latest ruling in the case of Her Majesty The Queen v Cameco Corporation (Cameco) has probably accelerated the necessity, according to Finance Canada, for changes to the law. This ruling was important because it was the first Canadian case to explore the recharacterization rules in sections 247(b) and (d) of the Act and established a precedent that affected both the lawmaking and administrative aspects of transfer pricing.

The proposed laws.

After observing Cameco, it became clear that the existing regulations, particularly when it came to applying the arm's length principle, were not defined enough. This lack of specificity could cause taxpayers and courts to interpret the rules in many different ways. The outcome in the Cameco case was that a large portion of their profits were taxed outside of Canada, even though it appeared that they didn't perform many activities in that jurisdiction. Finance Canada has recognized these concerns and in their consultation paper released on June 6, 2023, they suggested making changes to subsections 247(1) and (2) of the Act.

The suggested changes to the laws aim to incorporate existing global methods, which can be seen in the OECD's Transfer Pricing Guidelines for 2022. Furthermore, Finance Canada believes that there is a need for more guidance in applying the arm's length principle.

The resulting objective is to incorporate a two-step assessment of comparability, along with a corresponding set of fresh regulations.

The first step encompasses determining a baseline for the comparison at the core of the arm's length principle via three components:

Step 2 establishes the criteria for conducting the comparison, specifying whether the circumstances are different from what they would have been if the participants interacted with each other from a reasonable distance in similar situations.

Finance Canada is also planning to get rid of the current rules that define how certain transactions are categorized, and instead, include rules that say those transactions will not be recognized and will be replaced with transactions that are more similar to the original. Additionally, they will add a definition for a multinational enterprise group and update the definition of Transfer Price.

In conclusion, the suggested changes seek to establish harmony between the transfer pricing adjustment rule stated in subsection (2.02) and the Transfer Pricing Guidelines for 2022 mentioned in subsection (2.03). Although the Transfer Pricing Guidelines are currently considered as a helpful reference, they do not have any legal or authoritative power in Canadian legislation or judicial decisions. Like other countries, implementing a consistency rule would mean that the domestic transfer pricing laws should be applied in a manner that aligns with the Transfer Pricing Guidelines to the best extent possible.

Effects on administrative measures.

In addition to these legal changes, several administrative steps could be taken to lessen the burden of compliance, enhance tax predictability, and bring Canadian transfer pricing requirements in line with international standards.

One of the initial steps in this process involves implementing a consistent method of recording information, which focuses on the Master file, the Local file, and the Country-by-Country Report. These documentation techniques are derived from the OECD's BEPS Action 13 Final Report. The aim of the government is to find a middle ground that meets the Canada Revenue Agency's (CRA) requirements for prompt, precise, and pertinent data for risk evaluations and streamlined audits, while also avoiding placing undue or unnecessary obligations on taxpayers.

Additionally, the authorities are contemplating measures for transactions with lower risks or for taxpayers with smaller scale operations. These measures aim to streamline the documentation requirements related to transfer pricing in such cases. One potential solution being evaluated, provided the taxpayer meets the criteria, would be to enable them to fulfill the transfer pricing documentation obligations by submitting an annual report schedule.

Another suggested action is to modify the existing punishment regulations for transfer pricing stated in subsection 247(3) to align with current inflation rates. Consequently, the fixed limit specified in the regulation would rise from $5 million to $10 million, while still keeping the relative limit at 10% to promote adherence among smaller taxpayers.

At long last, Finance Canada acknowledges that simplifying transfer pricing methods can alleviate the burden of complying with regulations for taxpayers and, in turn, lessen the occurrence of transfer pricing conflicts. Consequently, the consultation is exploring the possibility of implementing uniform approaches for low-value intra-group services, returns on distribution activities, and introducing new regulations for intra-group loans. These rules may include imposing a maximum term of five years for loans, taking into account the credit rating of the multinational enterprise (MNE) group, and eliminating subordination features and embedded options.

Canada's finance department is suggesting a major revamp of the transfer pricing framework, which hasn't seen such significant changes since the inclusion of section 247. These recommendations aim to enhance tax predictability, lessen the burdens of compliance and administration, and adopt internationally recommended strategies from the OECD's Transfer Pricing Guidelines and the BEPS initiative to harmonize with other countries.

Many people saw the Cameco decision as not aligning with the OECD's recent BEPS guidance. Therefore, Finance Canada's commitment to bringing Canadian transfer pricing rules in line with international standards should reduce some of the uncertainty that arose after the Cameco decision. If the non-recognition and replacement provisions are adopted, it will be interesting to see if the CRA starts using these provisions more frequently than it did with the recharacterization provision. The Cameco decision significantly limited when the CRA could recharacterize a transaction, and only time will tell if the courts will apply the proposed non-recognition and replacement provisions more broadly. It is not surprising for Finance Canada to want to provide the CRA auditors with another tool, in addition to the standard transfer pricing adjustment provision.

Finance Canada is seeking input and feedback on the proposed modifications until July 28, 2023.