Transfer pricing
By John C. Hollas
Illustration: Susanna Denti
How to apply the appropriate transfer pricing methods to intercompany financial transactions
In Canada, taxpayers are seeing an increased scrutiny of and more audit focus on intercompany financing transactions by the international tax auditors from the Canada Revenue Agency. The related party financial transaction being most commonly audited by the CRA are intercompany loans, factoring of trade receivables and provision of financial guarantees.

This environment of rising transfer pricing controversy risk with respect to intercompany financial transactions conflicts directly with the multinational corporation's (MNC) increasing need to finance its foreign operations through intercompany, crossborder financial transactions.

The transfer pricing risks and implications remain very significant both from a tax compliance standpoint and from a controversy risk management perspective. Today, MNCs need to mitigate the risk of significant transfer pricing adjustments by local and foreign tax authorities. While our focus is limited to the Canadian tax environment, it is critical to recognize that in all international related party transactions, with financial transactions being no exception, the transfer pricing issues include the other tax jurisdictions of the foreign related parties that are involved in the intercompany transaction. As such the transfer pricing legislation in those foreign tax jurisdictions must be considered.

It is worth recalling that for most countries, including Canada, the underlying transfer pricing legislation is based on the arm's-length principle. Specifically the transfer pricing methodology, in determining the arm's-length price, is outlined in the CRA's administrative guidelines contained in the Information Circular IC 87-2R, which is essentially to consider the appropriate transfer pricing methods (TPM) according to a natural hierarchy. In brief the natural hierarchy of TPMs consists of traditional transaction methods (i.e., comparable uncontrolled price [CUP] method, resale price method and cost plus method) and then the transactional profit methods (i.e., profit split method or transactional net margin method).

Given the CRA's scrutiny of intercompany financial transactions, there is an urgent need for Canadian MNCs to properly select and apply the most appropriate transfer pricing methods to determine arm's-length pricing. The following is a discussion of how or if these methods can be applied to some types of intercompany financial transactions. Example 1: Intercompany loans from a Canadian MNC (Parent Co.) to its foreign subsidiary (Outbound Intercompany Loan: Inbound Interest Payments).

In the early, or growth, phase of establishing a foreign subsidiary the Canadian parent would likely provide funding to the foreign operation by way of an intercompany advance or loan. In some cases, the foreign subsidiary does not have the capacity to incur debt from third party lenders on a standalone basis or at economically efficient interest rates.

The preferred TPM is the CUP method, which is essentially a benchmarking of the intercompany loan interest rate to that found in comparable uncontrolled loan transactions that meet the degree of comparability standards as outlined in the OECD guidelines. If these comparability factors have an impact on the level of an arm's-length interest rate, the taxpayer will need to make adjustments for the differences or, in the absence of these adjustments, would be unable to rely upon the uncontrolled transactions to benchmark the interest rate. There are, arguably, numerous comparability factors that would have a significant influence on the level of interest rates to be charged, such as the borrower's credit risk, cost of funds for the lender, security pledged and, among other things, major loan covenants.

The other TPMs are, as a general rule, not applicable in determining the arm's-length price for the intercompany loan transaction but could be used to corroborate the results of the CUP method. A discussion on the exceptions to this rule is beyond the scope of this article.
Example 2: Canadian MNC is entering into a nonrecourse factoring transaction by selling its trade receivables to a captive offshore factoring company.

There are a number of business reasons why a MNC may enter into factoring transactions. These may include maximizing debt financing requirements for funding accounts receivable, implementing a risk-aversion strategy with respect to customer credit risk, and centralizing certain business functions (e.g. credit and collections) to achieve cost efficiencies.

The transfer pricing issue is in determining the arm's-length price for the bundle of potential services being provided in a factoring transaction. In most cases the CRA will look at the components of the factoring transaction and then determine the arm's-length price for each of the component services being provided. The price of the factoring transaction would involve determining; * an arm's-length interest rate for the financing component; * an arm's-length price for the transfer of credit risk related to the trade receivables; and * an arm's-length price for the related factoring services being provided (e.g., credit and collection services).
The determination of the arm's-length interest rate for the financing component is similar to the discussion in Example 1.

The sale of trade receivables on a non-recourse basis is effectively a transfer of the credit risk inherent in the portfolio of receivables being factored. Notwithstanding that there are arm's-length receivable sales transactions, including securitization, there is rarely any reliable data that would determine the arm's-length price of the credit risk. The transfer pricing challenge is to use arm's-length credit risk valuation models that would estimate the price of the credit risk being assumed.

The arm's-length charge for related factoring services is similar to the transfer pricing issues around intra-group services. In a shared services model, the MNC may wish to reduce costs by centralizing certain business functions as well as the related risks. Typically the business functions that are part of a shared services model are accounting, information technology, call centres and, for the purposes of this discussion, treasury operations and credit risk management functions. In the absence of an exact CUP, the transfer pricing method is usually based on the costs of providing the services as a direct charge or as an allocation of total costs of the shared service centre to the recipients.

Factoring transactions, especially if the captive factoring company is located in a tax haven, are routinely challenged by the CRA. In most cases the CRA states that merely obtaining quotes from a number of third-party factoring companies for the contemplated sale of a trade receivables portfolio would not be equivalent to a comparable uncontrolled factoring transaction and therefore would not produce a CUP. In an arm's-length factoring transaction, the CRA believes the parties would start negotiations based on the quote as an offer, but would in all likelihood expect some downward movement of the price to a level acceptable to the Canadian MNC. If the parties cannot arrive at a transaction price or if the seller of the trade receivables considers the factor rate to be in excess of the benefits received, then there would likely be no factoring (commercial) transaction.

The transfer pricing adjustment risk for intercompany factoring transactions is considered to be extremely high if the taxpayer has used market factor rates (either obtained directly through quotes from third-party factoring companies or in a benchmarking exercise of factor rates), without consideration of the benefit of the factoring transaction to the recipient, the Canadian MNC.
Example 3: Canadian parent (MNC) provides loan guarantees to third-party lenders of its foreign subsidiary.

The provision of a loan guarantee by the Canadian MNC is a variation on the intercompany loan as outlined in Example 1. The difference is the foreign subsidiary receives financing for its operations directly from a third-party lender with credit enhancement in the form of a loan guarantee provided by the Canadian MNC.

The CRA's position with respect to the characterization of the guarantee fee is that it is a payment for the provision of a service. The transfer pricing methodology for services is outlined in Chapter VII of the OECD guidelines and in Part 6 of the CRA's 7-2R for appropriate guidance on the methodology. In particular we note that paragraph 159 in IC 87-2R reinforced the OECD's view that the price of any service (i.e., guarantee fee) must be considered from both the renderer's and recipient's perspectives. This is essentially the benefits test applied to the recipient (or beneficiary) of the loan guarantee. In our example the recipient is the foreign subsidiary.

The benefit of the loan guarantee to the recipient would seem, at first glance, to be relatively easy to quantify, as the calculation of the maximum benefit obtained by the foreign subsidiary is the difference between the interest rate without the guarantee and the lower interest rate with the guarantee. However, as arm's-length parties would look to share the economic benefit of this interest rate reduction, the payment to the Canadian parent for the guarantee would be some portion of the interest rate savings that occurs due to the credit enhancement from the Canadian MNC's guarantee.

The main transfer pricing issue is to determine the quantum of the economic benefits and the appropriate split of that benefit between the two parties. Based on an understanding of the facts and circumstances surrounding the specific financial transaction and an evaluation of the rel-ative contribution of the Canadian MNC to obtaining the interest rate reduction, the quantum of the guarantee fee can be estimated.

The CRA no longer limits its transfer pricing audits to exchanges of tangible property, intangibles and services. International financial transactions between related parties present another layer of transfer pricing complexity for the Canadian MNC that needs to be considered. These transfer pricing issues need to be identified and documentation put in place to adequately deal with the CRA transfer pricing audit challenges that are on the horizon.

John C. Hollas, director, transfer pricing, Deloitte & Touche LLP
Technical editor: Michel Lanteigne, FCA, managing partner, tax for Canada, Ernst & Young LLP RELATED LINKS
Information Circular 87-2R, Canada Revenue Agency
OECD, Transfer pricing guidelines for multinational enterprises and tax administrations
Transfer pricing audits now the rule, says E&Y survey, CAmagazine
Do the documents right, by Titus I. Deac, CA magazine, January-February 2003
Comparable uncontrolled price (CUP) method, Canada Revenue Agency