Applying The Transfer Pricing Rules To Guarantees

At the time Canada was amending its transfer pricing rules, much concern – and some confusion – arose over the potential application of the rules to financial transactions.

This was particularly the case where the tax consequences of applying those rules to financial transactions were already regulated under other provisions of the Canadian Income Tax Act. In response to these concerns, Canada Revenue Agency (CRA) made a number of statements in Information Circular 87-2R – International Transfer Pricing about the possible application of the general transfer pricing provisions in section 247 as follows:

• In general, section 247 does not change the existing law as it relates to inter-corporate debt and equity investments.
• As a general rule, the specific provisions of the Act – relating to loans and other indebtedness to or from non-residents, which are contained in sections 17 and 80.4, subsections 15(2) and 18(4) – would be applied before considering the more general provisions of section 247.
• Specific provisions in the Act deal with inter-company debt and the associated interest charges. However, credit terms and financing arrangements are among the many related factors to be considered in the evaluation of transfer prices.

A recent comfort letter issued 11 March 2003 by the Department of Finance suggests that they are willing to entertain amendments to section 247 to deal with issues relating to financing transactions. In the letter, the Department of Finance considered a taxpayer request that section 247 be amended to introduce an exception for guarantees provided by Canadian resident corporations in respect of controlled foreign affiliates. The request specifically sought an exception which would parallel an existing exception in subsection 247(7) for loans to controlled foreign affiliates under section 17 of the Act.

Under section 17, there is a deemed income inclusion where a corporation resident in Canada makes a loan or has an amount receivable from a non-resident of Canada, which is outstanding for more than one year, and interest on the debt is at less than a reasonable rate. In general, paragraphs 17(8)(a) and (b) provide for an exclusion from these rules in respect of loans or advances to a controlled foreign affiliate where:

• The affiliate used the money for the purpose of earning income from an active business or to make a loan to another controlled foreign affiliate where the money is used by the second affiliate for the purpose of earning income from an active business, or
• The loan arose in the course of an active business carried on by the affiliate.

Subsection 247(7) of the Act provides that the general transfer pricing rules do not apply to an amount that qualifies for the exclusion in paragraphs 17(8)(a) and (b).

In the comfort letter, the Department of Finance expressed the view that it would be appropriate in tax policy terms to provide an exception for guarantees which parallels that provided in respect of "section 17" loans from Canadian resident corporations to controlled foreign affiliates.

A draft amendment was attached to the comfort letter proposing that a new subsection be added – 247(7.1) – which would exempt certain guarantees from the application of section 247.The amendment provides that section 247 does not apply to guarantees given by a Canadian parent corporation in respect of the repayment of an amount owing by a non-resident person to lender, if:

1. The parent provided the guarantee pursuant to an agreement in writing entered into with the lender or with a person or partnership related to the lender;
2. The non-resident person is a controlled foreign affiliate of the parent for the purpose of section 17 throughout the period in the particular year during which the amount owing is owing.
3. It is established that the amount owing would, if the amount owing were an amount owing to the parent, be an amount owing described in paragraph 17(8)(a) or (b).

While in broad terms, the proposed addition of this exception was welcomed by taxpayers and the tax community, concerns have been raised over the first requirement in 247(7.1)(a). Specifically, parent guarantees can be given for legitimate business reasons under circumstances where there may not be an agreement in writing with the lender or a person or partnership related to the lender. An example would be a guarantee given by a Canadian parent corporation in respect of public debt issued by a controlled foreign affiliate, where the guarantee is given to support the credit rating on the debt.

If the pattern to date is any indication, as more and more fact patterns present themselves for the potential application of section 247 and other more specific provisions of the Act, we can probably expect to see more fine tuning of section 247 and the addition of further exceptions to it.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.