Canada: Transfer pricing, GAAR and tax planning dominating Canadian taxpayers’ and advisers’ time

If you are dealing with revenue authorities in Canada you should hire a tax expert. This sounds like self-promotion or an advertisement for tax specialists in Canada, but advisers at Miller Thomson explain why, in the end, it will save you money.

In Canada, we have various levels of government and complex systems of tax administration and enforcement. We have municipal, provincial and federal levels of taxation. The Constitution Act, 1982 (the Act) gives the Canadian parliament the exclusive jurisdiction over the raising of money by any mode or system of taxation. The Act also provides each province with exclusive jurisdiction over direct taxation within the province in order to raise revenue for provincial purposes. Because of these statutory powers, we have plenty of federal and provincial legislation that pertains to income taxes (both at the personal and corporate levels), excise taxes, sales taxes, commodity taxes (such as tobacco, alcohol and fuel taxes), corporation capital taxes, property taxes, estate taxes and many more types of taxes. It is important to note that with the exception of Quebec, in Canada all of the provinces and territories follow the common law system. The province of Quebec follows the civil code.

We have different courts that deal with different types of tax problems. You have to know in what jurisdiction your problem lies in order to determine the correct court and procedure. For example, for most civil tax litigation issues, the Tax Court of Canada is the likely starting point. However, in certain areas, such as rectification, you may proceed to the provincial court, or challenging a 'requirement', may cause you to file an application with the Federal Court. Finally, criminal prosecutions will be conducted in the provincial court system following the Criminal Code rules of criminal procedure.

Now that we have given you a sense of the complexity of our taxation system, we will turn to highlight the topics and areas which are currently dominating the time of taxpayers and their advisers in Canada.

In Canada, legislation has been enacted which governs transfer pricing, and the Canada Revenue Agency (CRA) has developed administrative policies and guidelines aimed at providing additional guidance with respect to transfer pricing. Section 247 of the Income Tax Act (ITA) is the central piece of transfer pricing legislation in Canada. This section mandates arm's-length transfer prices for transactions with non-arm's-length non-residents. The most notable recent policy pronouncement from the CRA came in March 2014 when the CRA updated one of its transfer pricing memoranda. The new policy is aimed at the specific requirements for adherence to the rules regarding contemporaneous documentation. This memorandum, known more commonly as TPM-05R, indicates that the CRA has no tolerance whatsoever for the failure to rigidly follow the filing deadlines and the actual provision of documents. In the past, the CRA was more forgiving and taxpayers merely had to have at-the-ready documents, if requested, for further review and/or investigation by the CRA. Not any more. This policy shift reflects the increasingly tough approach by the CRA. This is made even more evident by the potential for the imposition of heavy penalties. Some observers have suggested that to some extent this policy shift is attributable to the fairly recent Tax Court of Canada decision in McKesson. In this transfer pricing appeal, Justice Boyle was critical of the taxpayer's contemporaneous documentation and the CRA's decision not to impose penalties (see McKesson Canada Corporation v. The Queen (2013) TCC 404. The case has been appealed to Canada's Federal Court of Appeal).

Tax avoidance is regulated by the ITA's general anti-avoidance rule (GAAR) contained in section 245. The provision is designed to prohibit aggressive tax avoidance and applies where a transaction or series of transactions results in a tax benefit, and the transaction or series of transactions were not undertaken or arranged primarily for any bona fide purposes other than for the purpose of obtaining the tax benefit. Where these criteria are met, the CRA may invalidate the tax benefit that resulted from such transaction or transactions.

There are three requirements to uphold an application of the GAAR. First, a tax benefit must have been gained from the transaction or transactions. Second, it must be shown that the primary purpose of the transaction or transactions was to obtain a tax benefit. Third, the benefit obtained from such transaction or transactions must be shown to be inconsistent with the purpose, object or intent of the provision(s) of the ITA used by the taxpayer to receive the tax benefit.

Since the GAAR was first introduced in 1988 it has become – particularly in recent years – a very hotly litigated matter. Some common tax litigated issues appear to be surplus strips, loss creations via stock dividends, capital and non-capital issues, and Part I.3 tax.

In more recent years, specifically in 2013, the government enacted section 237.3 of the ITA that requires the disclosure of 'reportable transactions' to the CRA. The purpose of this requirement was to address concerns about aggressive tax avoidance by imposing penalties on tax advisers, rather than on taxpayers.

In 2014, in response to the OECD's Base Erosion and Profit Shifting (BEPS) Action Plan, the federal government introduced a number of measures in the Budget to address international aggressive tax avoidance. Specifically, the Budget aimed at the following:

• Ensuring that financial institutions do not avoid paying Canadian tax on income associated with the insurance of Canadian risks through the use of derivative insurance swap arrangements between foreign affiliates of Canadian taxpayers and third parties.

• Ensuring that the offshore regulated bank provisions are not inappropriately used to circumvent the foreign accrual property income rules through foreign affiliates that are not part of a Canadian financial institution group.

• Ensuring that non-residents cannot avoid Canadian withholding tax or thin capitalisation rules by entering into back-to-back loan arrangements with third party financial intermediaries to effectively make indirect loans to their Canadian subsidiaries.

• Inviting comments from stakeholders on a proposed rule to prevent treaty shopping.

• Inviting input from the public on issues related to international tax planning by multinational enterprises and other cross-border tax integrity issues, such as ensuring the effective collection of sales tax on e-commerce sales to Canadians by foreign-based vendors.

Another prominent topic in Canada is the foreign affiliate dumping (FA Dumping) rules introduced in October 2012. The enacted provisions significantly changed the August 14 2012 draft of the legislation, which substantially changed the initial draft legislation, released on March 29 2012. On August 16 2013, the government proposed additional amendments to the FA Dumping rules.

The FA Dumping rules generally apply where an investment in a non-resident corporation (a subject corporation) is made by a corporation resident in Canada (a CRIC) and the subject corporation is, or becomes, a foreign affiliate of the CRIC, the CRIC is, or becomes, controlled by a non-resident corporation, and none of the explicit exceptions, discussed generally below, apply. Where the FA Dumping rules apply, the CRIC is deemed to have paid to the non-resident parent corporation a dividend equal to the fair market value of any properties transferred, obligations assumed or incurred, or benefits otherwise conferred by the CRIC, or property transferred to the CRIC in repayment of an amount owing to the CRIC. In addition, the paid-up capital (PUC) of the shares of the CRIC held by the non-resident parent corporation is reduced by the amount of any PUC increase that can reasonably be considered to relate to the investment. The deemed dividend results can result in part XIII withholding tax unless a dividend substitution election is available. In certain circumstances, the PUC reduction referred to above can be reinstated.

An investment is very broadly defined to include a share acquisition, a contribution of capital, an acquisition of a debt obligation, an extension of the maturity date of a debt obligation, and an acquisition by the CRIC of shares of the capital stock of another Canadian resident corporation of which the subject corporation is a foreign affiliate if the total fair market value of foreign affiliate shares owned directly or indirectly by the other Canadian resident corporation is more than 75% of the total fair market value of all of the other Canadian resident corporation's assets. The indirect acquisition type of investment led to significant debate when the FA Dumping rules were introduced and evolved from a 50% test to the currently enacted 75% test.

The two explicit exceptions to the FA Dumping rules are the 'more closely connected' exception and an exception for certain corporate reorganisations. Given the nature of, and the traditional decision-making responsibilities associated with a multinational corporation, it will be rare for the 'more closely connected' exception to apply. In addition to these explicit exceptions, where a CRIC and its non-resident corporate parent elect to have a debt that would be an 'investment', a pertinent loan or indebtedness (a PLOI), the FA Dumping rules will not apply. Where a PLOI election is made, the CRIC will have deemed interest income in respect of such PLOI equal to a prescribed interest rate plus 4%.

Finally, another recent development in the area of international tax planning in Canada is the proposed back-to-back loan rules that were introduced in the federal budget released on February 11 2014. Under these proposed rules, a back-to-back loan exists where a taxpayer has an outstanding interest-bearing obligation owing to a lender (the intermediary) and the intermediary or any person not dealing at arm's-length with the intermediary (i) is pledged a property by a non-resident person as security in respect of the obligation, (ii) is indebted to a non-resident person under a debt for which recourse is limited, or (iii) receives a loan from a non-resident person on condition that a loan be made to the taxpayer. Where a back-to-back loan exists, all or a portion of the loan owed to the intermediary will be deemed to be owed by the taxpayer to the non-resident person. This may result in the interest no longer being deductible and the imposition of Canadian withholding tax on the interest deemed to be paid directly to the non-resident person under the deemed loan. The definition of a back-to-back loan is broad and therefore these rules will apply to various typical third party secured financing arrangements.

David Chodikoff and Crystal Taylor are partners at Miller Thomson. Christos Panagopoulos is an associate at the firm.

David Chodikoff, Crystal Taylor and Christos Panagopoulos Miller Thomson