Advance Pricing Agreements can Reduce Income Tax Uncertainty - PricewaterhouseCoopers LLP
Transfer pricing has become one of the most talked-about topics in international tax, for several reasons. Perhaps the most important is the fact that the world economy has become increasingly global. Markets not long ago considered separate and distinct are now seen as one. With many Canadian corporations (and not just multinationals) conducting more business abroad, issues involving inter-company transactions are surfacing.
Transfer Pricing
A transfer price is the amount a corporate entity charges to, or is charged by, related entities in another country for goods and services. That price is used in calculating the taxable income of the related entities, both in Canada and in the foreign country.
Revenue Canada and its foreign tax counterparts fear that related corporations can fix prices for their transactions with the goal of minimizing taxes globally. Many countries, including Canada and the United States, have developed transfer pricing rules to counteract these strategies. Two key elements are strict requirements for contemporaneous documentation and penalties for understatement or overstatement of transfer prices between related corporations.
Transfer prices have a direct effect on the amount of income taxes paid by a corporation, or related corporations, in more than one country, so any problems can put corporations at risk in several jurisdictions. They may face the possibility of double taxation.
In response to these transfer pricing issues, advance pricing agreements (APAs) are rapidly becoming an integral part of international tax. An APA is a binding agreement between a taxpayer (or several related taxpayers) and the taxation authorities of one or more countries that determines a transfer pricing methodology (or methodologies) to be used in pricing the goods and services of future transactions between those related taxpayers. The APA covers the transfer of goods and the various forms of transfer of services, including management services, research and development, cost sharing arrangements and the use of intangibles. An APA can also be seen as a process for resolving potential transfer pricing disputes before they actually arise.
APAs are gaining acceptance worldwide, although countries are at different stages in their implementation. Canada, the United States, Australia and Mexico, among others, already have systems to provide APAs on transfer prices between related corporations. Many other countries are refining their process. APAs are increasingly seen as the potential answer to the transfer pricing concerns of many multinationals.
A Method, Not a Price
An APA determines a method to fix transfer prices, not the appropriate price for specific goods or services. The APA incorporates a set of criteria and critical assumptions under which the proposed transfer pricing method would operate on future transactions.
With an APA request, a taxpayer has to provide explanations and analyses of the proposed transfer pricing method. These must comply with the requirements of the Income Tax Act and, therefore, must be consistent with the "arm's-length principle". Under this principle, transactions between parties not dealing at arm's-length should be executed on terms and at a price that one could reasonably expect in similar circumstances (i.e. similar product or service, credit terms reliability of supply) had the parties been dealing at arm's-length.
The following brief extract from an actual APA with the Internal Revenue Service in the United States demonstrates this attention to method:
"Taxpayer agrees to comply with the terms and conditions of this APA, including the transfer pricing methodology ("TPM") that is described in Appendix A. If Taxpayer complies with the terms and conditions of this APA, then the Service will not contest the application of the TPM to the Covered Transactions and will not make or propose any reallocation or adjustment under section 482 of the Code with respect to Taxpayer concerning the Transfer Prices in Covered Transactions for the years covered by this APA (the "APA years").
The APA Process
One or more pre-filing meetings may take place between the taxpayer, the taxpayer's representatives, and Revenue Canada. These meetings are an opportunity to meet Revenue Canada's APA officials and discuss their willingness to issue an APA in the particular circumstances of the taxpayer. Most importantly, parties can explore some of the issues involved, including the kind of information that will be required to be disclosed and the timing of the process.
After the pre-filing meeting, the taxpayer will formally request an APA from Revenue Canada, which (if it agrees) will send an acceptance letter. This letter constitutes the formal acceptance by both parties of the essence of the agreement. Several other meetings and negotiations with the tax authorities will occur over a period. During the rounds of negotiations, and prior to the conclusion of the APA, the taxpayer will be required to disclose a great deal to the tax authorities, including information:
- On existing transactions of goods and services between the taxpayer and related entities;
- About the detailed organizational structure of the operations of the taxpayer;
- Regarding the taxpayer's competitors and comparable businesses; and
- That was used to determine the proposed transfer pricing method, including a functional analysis economic studies and profitability calculations.
In most cases, the factual information disclosed to the tax authorities as part of the APA process is confidential and will be treated like any other information gathered by Revenue Canada during an audit. As such, it can be used by the tax authorities in the administration of the Income Tax Act. Taxpayers should take this into consideration in deciding whether to go forward with an APA request.
The APA process takes from 18 months to three years, according to recent experience. The meetings usually require that additional information be submitted to tax authorities and can be very demanding on the taxpayer.
The fees charged by Revenue Canada are "out-of-pocket" costs incurred in completing the APA. They vary from $5,000 to $40,000, but generally are in the vicinity of $20,000 (compared to approximately US$25,000 in the United States). Barring significant changes in the operations covered in the APA, the agreement can be renewed at the request of a taxpayer. The initial costs associated with the conclusion of the APA can accordingly be amortized over a number of years.
Prior Years
The APA is a prospective process that does not address prior years. However, if the methodology in the APA differs from that used in the prior years, it will likely affect those prior years. This point is one of the most important to consider in deciding to apply for an APA. In practice, Revenue Canada auditors will delay concluding their audits of open years until the APA is finalized.
Unilateral/Bilateral/Multilateral
An APA can be unilateral, bilateral or multilateral. Negotiations with other countries are conducted under the Competent Authority procedure of a relevant tax treaty. When an agreement is reached between Canada and a foreign country, a taxpayer has the assurance that both tax authorities will accept the transfer pricing methodology used in determining the transfer prices for the transactions covered by the APA. The risk of potential double taxation on transfer pricing issues is thereby reduced.
Advantages of an APA
An APA offers numerous advantages. For example, it assures a taxpayer and related taxpayers that no transfer pricing adjustments will be made over the period covered by the agreement if the terms and conditions set in the agreement are respected. Also, it significantly reduces the taxpayer's costs associated with transfer pricing audits by tax authorities, and will allow a taxpayer to be protected from penalties and interest for understatement or overstatement of income due to transfer prices. More importantly, it protects a taxpayer from any possibility of double taxation.
APAs are not for everyone. Some (typically smaller) companies, which are not regularly subject to tax examination, might feel that APAs bring them into more frequent contact with tax authorities than might otherwise occur. In many instances, however, the companies can expect to be examined regularly, so an APA could accelerate and simplify resolution of potentially difficult issues that the company otherwise would need to deal with in the more adversarial environment of examinations. Indeed, bilateral APAs have become a standard tool for large companies doing business both in Canada and the United States. In other circumstances, even for smaller companies, APAs can provide needed certainty, or can be used as vehicles to resolve pending examinations. All told, APAs can be a valuable tool in dealing with today's stricter environment of transfer pricing enforcement.
This article is based on one that appeared in "Emerging Tax Topics for 1998 and Beyond", a PricewaterhouseCoopers LLP (Canada) Tax Memo.
The information provided herein is for general guidance on matters of interest only. The application and impact of laws, regulations and administrative practices can vary widely, based on the specific facts involved. In addition, laws, regulations and administrative practices are continually being revised. Accordingly, this information is not intended to constitute legal, accounting, tax, investment or other professional advice or service.
While every effort has been made to ensure the information provided herein is accurate and timely, no decision should be made or action taken on the basis of this information without first consulting a PricewaterhouseCoopers professional. Should you have any questions concerning the information provided herein or require specific advice, please contact your PricewaterhouseCoopers advisor, or:
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