2010 Update of the OECD Transfer Pricing Guidelines

October 31, 2012

Legislative and policy changes

Please note that the following Transfer Pricing Memorandum, although correct at the time of issue, has not been updated to reflect subsequent legislative changes since the date of issue. As a result, some information may no longer be valid.

References and other information

This memorandum does not replace the law found in the Income Tax Act and its Regulations. Since this memorandum may not address your particular situation, you should refer to the Income Tax Act, any applicable Regulation, and relevant case law. For more information, you can contact a Canada Revenue Agency tax services office.

Introduction

The purpose of this Transfer Pricing Memorandum (TPM) is to provide an overview of the significant changes made in the 2010 version of the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the Guidelines) and of the Canada Revenue Agency's (CRA) position regarding these changes.

Information Circular IC87-2R, International Transfer Pricing, provides guidance with respect to the application of the transfer pricing rules in section 247 of the Income Tax Act. IC87-2R contains numerous references to the Guidelines as they read at the time of publication. This TPM will also provide an update to the references to the Guidelines contained in IC87-2R and address certain elements that will enable the IC to continue to be read harmoniously with the Guidelines. This TPM should be read in conjunction with the Guidelines and IC87-2R.

The 2010 changes to the Guidelines represent the Committee on Fiscal Affairs' continuing work in transfer pricing. The OECD encourages member countries to follow the Guidelines in their domestic transfer pricing practices and encourages taxpayers to follow the Guidelines in evaluating, for tax purposes, whether their transfer pricing complies with the arm's length principle.^{Footnote 1}

The Guidelines are a consensus document developed by participating countries on Working Party 6, Taxation of Multinational Enterprises, of the OECD. As such, no objections or reservations can be placed on them.

It is important to note that the CRA endorses the application of the arm's length principle and the 2010 version of the Guidelines for the administration of the Income Tax Act regarding transfer pricing matters.

Background

On July 22, 2010, the OECD released the 2010 version of the Guidelines. Chapters I to III of the Guidelines were substantially reorganized and revised to incorporate the experience acquired by tax administrations and taxpayers in the application of the Guidelines since they were released in 1995. Chapter IX is a new chapter focusing on the transfer pricing aspects of business restructurings.

The Guidelines are based on the arm's length principle, which follows the principles in the OECD Model Tax Convention on Income and on Capital (MTC). Article 9, Associated Enterprises, of the MTC provides the authoritative statement for the application of the arm's length principle. Paragraph 1 of Article 9 states:

"Where (…) conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly."

Paragraph 1 of the commentary to Article 9 states:

"This Article deals with adjustments to profits that may be made for tax purposes where transactions have been entered into between associated enterprises (…) on other than arm's length terms. Its conclusions are set out in the report entitled Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, which is periodically updated to reflect the progress of the work of the Committee in this area. That report represents internationally agreed principles and provides guidelines for the application of the arm's length principle of which the Article is the authoritative statement."

Significant changes

Chapter I, The Arm's Length Principle, lays the foundation for the Guidelines with a discussion of the arm's length principle. Most importantly, the OECD reaffirms its support for the arm's length principle.^{Footnote 2} The reader should refer to Chapters I to III and IX of the 2010 version of the Guidelines for a thorough review of the changes. This document highlights some of the significant changes, which include:

• Selection of the transfer pricing method
• Application of the transactional profit methods
• Performing a comparability analysis
• Transfer pricing aspects of business restructurings

Selection of the transfer pricing method

Chapter II, Transfer Pricing Methods, has been reorganized to include the discussion of all transfer pricing methods in one chapter. One significant change is in the selection of the transfer pricing method where the hierarchy of methods has been replaced by the "most appropriate transfer pricing method to the circumstances of the case." The criteria to consider in determining the most appropriate method to the circumstances of the case are:

"(…) the respective strengths and weaknesses of the OECD recognised methods; the appropriateness of the method considered in view of the nature of the controlled transaction, determined in particular through a functional analysis; the availability of reliable information (…) needed to apply the selected method and/or other methods; and the degree of comparability between controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate material differences between them."^{Footnote 3}

Paragraph 2.3 of the Guidelines further refines this criteria by stating that "(…) where, taking account of the criteria described at paragraph 2.2, a traditional transaction method and a transactional profit method can be applied in an equally reliable manner, the traditional transaction method is preferable to the transactional profit method. Moreover, where, taking account of the criteria described at paragraph 2.2, the comparable uncontrolled price method (CUP) and another transfer pricing method can be applied in an equally reliable manner, the CUP method is to be preferred."

The 2010 version of the Guidelines essentially suggests that there is no strict hierarchy to be applied to the selection of a transfer pricing method. Rather the focus should be on the quality of the data that is available and, consequently, what will be the most appropriate method. At the same time, the Guidelines continue to suggest that there exists a natural hierarchy to the methods, as referred to in paragraph 2.3. The CRA agrees that the focus of determining the method to use should be the method that will provide the most direct view of arm's length behaviour and pricing. IC87-2R states that a natural hierarchy exists in the methods. Both IC87-2R and paragraph 2.3 of the 2010 version of the Guidelines state that the traditional transaction methods (e.g. CUP) are preferred over a transactional profit method. For the CRA, these changes do not firmly de-emphasize the natural hierarchy but they refocus the topic on what is truly relevant—the degree of comparability available under each of the methods and the availability and reliability of the data.

Application of the transactional profit methods

Another significant change is the additional guidance in Chapter II on the application of the transactional profit methods. The discussion includes criteria to consider when selecting the most appropriate net profit indicator, determining the net profit, weighting the net profit, using the Berry ratio and applying the profit split method.

The CRA believes this section of the Guidelines provides valuable expanded guidance on the application of the arm's length principle by means of transactional profit methods.

Performing a comparability analysis

Chapter III, Comparability Analysis, is almost entirely new (some sections were reorganized from Chapter I).^{Footnote 4} The most significant change is the new guidance on performing a comparability analysis. As part of the process of selecting the most appropriate transfer pricing method and applying it, the analysis always aims at finding the most reliable comparables. The new guidance provides a "typical process" for performing a comparability analysis, describing each step in detail. Although not compulsory, this "typical process" is considered good practice by the OECD. Whatever process is adopted, it should be methodical, consistent and transparent.

The OECD's "typical process" as outlined in paragraph 3.4 of the Guidelines is as follows:

Step 1: Determination of years to be covered.

Step 2: Broad-based analysis of the taxpayer's circumstances.

Step 3: Understanding the controlled transaction(s) under examination, based in particular on a functional analysis, in order to choose the tested party (where needed), the most appropriate transfer pricing method to the circumstances of the case, the financial indicator that will be tested (in the case of a transactional profit method), and to identify the significant comparability factors that should be taken into account.

Step 4: Review of existing internal comparables, if any.

Step 5: Determination of available sources of information on external comparables where such external comparables are needed taking into account their relative reliability.

Step 6: Selection of the most appropriate transfer pricing method and, depending on the method, determination of the relevant financial indicator (e.g. determination of the relevant net profit indicator in case of a transactional net margin method).

Step 7: Identification of potential comparables: determining the key characteristics to be met by any uncontrolled transaction in order to be regarded as potentially comparable, based on the relevant factors identified in Step 3 and in accordance with the comparability factors set forth at paragraphs 1.38 through 1.63.

Step 8: Determination of and making comparability adjustments where appropriate.

Step 9: Interpretation and use of data collected, determination of the arm's length remuneration.

Although section 247 of the Income Tax Act does not prescribe a particular structure for undertaking a comparability analysis, the CRA endorses the "typical process" outlined in the Guidelines. In performing this analysis, taxpayers are required to make reasonable efforts to determine and use arm's length prices or allocations in respect of transactions or series. Where reasonable efforts are not made, a taxpayer may be subject to reassessments and penalties.

Transfer pricing aspects of business restructurings

Chapter IX, Transfer Pricing Aspects of Business Restructurings, is a new chapter focusing on the transfer pricing of business restructurings. Business restructurings mean "the cross-border redeployment by a multinational enterprise of functions, assets and/or risks"^{Footnote 5} and are typically accompanied by a reallocation of profits among the members of the multinational enterprise, either immediately after the restructuring or over a few years. The issues are whether the reallocation of profits is consistent with the arm's length principle and how both Article 9 of the MTC and the arm's length principle apply to business restructurings.

The guidance in Chapter IX consists of four parts which should be read together. The Guidelines state that risks are critically important and are an essential part of any functional analysis, thus Part I focuses on the special considerations for risks. In that regard, it is important to review the contractual terms, the conduct of the parties, the allocation of the risks, and the consequences of that allocation.

For transfer pricing purposes, the CRA is entitled to challenge the purported importance of a contractual allocation of risk between associated enterprises if it is not consistent with the legal substance and/or application of the arm's length principle, as described in section 247 of the Income Tax Act. Relevant but not determinative factors to consider are the identification of the party performing the functions which lead to the assumption of risk in fact, and the party with active control over that risk.

Part II, Arm's length compensation for the restructuring itself, discusses restructuring transactions and whether the conditions imposed and compensation or indemnification provided respect the arm's length principle. For such matters, it is important to identify the restructuring transactions, evaluate the rights and obligations of the parties, understand their business reasons, examine their expected benefits, and examine the options realistically available to them. It is important that the functions, assets, and risks in the pre- and post-restructuring transactions are well understood.

Part III, Remuneration of post-restructuring controlled transactions, discusses the compensation for transactions occurring between parties after the restructuring. The arm's length principle and the Guidelines apply equally to restructuring and post-restructuring transactions, as they do to comparable transactions that were structured as such from the beginning. Comparable situations must be treated similarly. However, factual differences could exist between situations, which may affect the outcome of the comparability analysis. For example, a post-restructuring arrangement that is negotiated between parties with a prior relationship could affect the options that are realistically or reasonably available to them, given differences in market positions, prior arrangements, and other circumstances.

Part IV, Recognition of the actual transactions undertaken, provides additional guidance on the application of paragraphs 1.64 to 1.69 of the Guidelines (the two circumstances in which a transaction is not recognized for transfer pricing purposes).

Part IV reflects that, if an appropriate transfer price can be determined in the circumstances of the case (irrespective of the fact that the transaction or arrangement may not be found between independent enterprises and the tax administration may have doubts as to the commercial rationality of the multinational enterprise member entering the transaction), the transaction or arrangement would not be disregarded. If an appropriate transfer price cannot reliably be determined, the transactions may not be recognized if they are the result of conditions that would not have existed between independent enterprises.

Subsection 247(2) of the Income Tax Act and paragraphs 11 to 13 of IC87-2R set out the legislative framework and the CRA's policy in this regard.

Conclusion

The 2010 version of the Guidelines applies to all years available for audit, including transactions that were completed before July 22, 2010. The revisions are a clarification and elaboration of the Guidelines, which serves to inform or provide guidance and principles on how to apply the arm's length principle to achieve an arm's length result. Since the revisions are intended to increase clarity in the application of the arm's length principle, the revisions should apply to all treaties, including treaties concluded prior to the release of the revised Guidelines.

IC87-2R, International Transfer Pricing, dated September 27, 1999, should be read together with the 2010 changes in mind (see Appendix A).

Appendix A

Given the changes made in the 2010 version of the Guidelines, certain paragraph references in IC87-2R are no longer valid. Below are revised paragraph references which enable the IC to continue to read harmoniously with the Guidelines.

• IC87-2R paragraph 30 – The reference to paragraph 1.15 should now be to paragraph 1.33.
• IC87-2R paragraph 32 – The reference to paragraphs 1.19 through 1.35 should now be to paragraphs 1.38 through 1.63.
• IC87-2R paragraph 38 – The reference to paragraph 1.42 should now be to paragraph 3.9.
• IC87-2R paragraph 44 – The reference to paragraph 1.37 should now be to paragraph 1.65. In addition, in order to correct a misquote of the Guidelines, the last sentence of this paragraph is revised to read "The OECD Guidelines identify two exceptional situations where disregarding a transaction would be considered."
• IC87-2R paragraph 49 should read to reflect the change in paragraph 2.2.
• IC87-2R paragraph 52 – The references to OECD paragraphs are deleted and this paragraph now reads "The traditional transaction methods are preferable to the transactional profit methods and the transactional profit methods are used as methods of last resort, when the use of traditional transaction methods cannot be reliably applied or cannot be applied at all."
• IC87-2R paragraph 85 – The reference to paragraph 2.37 should now be to paragraph 2.44.
• IC87-2R paragraph 182 – The reference to paragraphs 1.20 through 1.27 should now be read as paragraphs 1.42 through 1.51.