BIBA Luncheon

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BIBA Luncheon

Barbados November 25, 2008
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Canada Barbados Tax Treaty

• In 1980, Canada ratified a Double Taxation Treaty
  with Barbados (the Treaty)
• The Treaty allowed Canadian corporations to
  establish an International Business Company
  (IBC) in Barbados
• IBCs allow Canadian corporations to take
  advantage of certain tax benefits and avoid
  double taxation
• An IBC must be set up to allow a corporation to
  continue international manufacturing or
  international trade and commerce from within
  Barbados

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Tax Advantages of the Treaty

• Advantages to Canadian IBCs in Barbados include
• Avoidance of double taxation (dividends paid out
  to foreign affiliates are fully deductible to the
  recipient)
• Low marginal tax rates
• 2.5 on income up to 10M
• 2 on income from 10M to 20M
• 1.5 on income from 20M to 30M
• 1 on income exceeding 30M
• May elect credit for tax paid in other countries

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Other Benefits

• IBCs may extract dividends, royalties, interest,
  fees or management fees tax-free from Barbados if
  paid to
• a company carrying on international business, or
• a person residing outside of Barbados
• No tax on the transfer of securities or assets of
  the IBC
• Additional Benefits to IBCs
• books and records may be kept outside of Canada
• exempt from paying direct tax on profits and
  gains in respect of an income year
• may import materials and equipment for its
  business duty-free

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Tax Savings Example

• A Canadian company netting 100K in income would
  pay tax of 30K in Canada
• An IBC set up in Barbados netting 100K in income
  pays only 2.5K
• The remaining 97.5 of income can be returned to
  Canada in the form of a tax-free dividend
• The approximate cost of operating a Barbados IBC
  is 3K
• Savings to the Canadian company is 24.5K

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Use of Transfer Pricing

• One way a multinational corporation can achieve
  and maintain tax savings after setting up an IBC
  in Barbados is by establishing effective
  intercompany pricing strategies
• This requires an understanding of transfer
  pricing

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What is Transfer Pricing?

• Transfer pricing involves the price that a member
  of a multinational group charges a related party
  operating in a different tax jurisdiction for
  goods, services and/or intangibles
• Transfer pricing requires prices between related
  parties be set such that related parties are
  compensated for the functions, assets and risks
  assumed
• The more risks assumed by a related party, the
  more profit they should earn

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Why Should Transfer Pricing be a Concern

• Governments targeting Transfer Pricing
• Increasing compliance requirements
• Double taxation
• Non-deductible interest and penalties

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Canadas Regulatory Environment

• Section 247 of the Income Tax Act (ITA)
• Information Circular (IC) 87-2R International
  Transfer Pricing
• IC 71-17R5 Guidance on Competent Authority (CA)
  Assistance Under Canadas Tax Conventions
• IC 94-4R Advance Pricing Arrangements (APAs)
• IC 94-4R (Special Release) APAs for Small
  Businesses

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CRA - Transfer Pricing Compliance

• Tax Services Office
• Head Office Support - What role does the
  International Tax Division have in the audit?
• What are some of the dispute mechanisms available
  to relieve corporations of double tax?
• What is the Competent Authority? What happens to
  your file in CA?

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Working with the Realities of Transfer Pricing
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Working with the Realities of Transfer Pricing

• Strategically placing functions, assets and risks
  in low tax jurisdictions can provide significant
  after tax savings
• Such a strategy requires transactions be well
  documented with a clear illustration of how
  related parties contribute to generating profits
• Proper planning can result in more favorable
  after tax outcomes being realized for a
  multinational
• Greater compliance and planning will result in
  reduced controversy
• More aggressive tax structures will lead to
  increased controversy with tax authorities

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Hot Audit Issues and Other Developments

• Even when transactions are documented, this does
  not prevent governments from raising adjustments
  through section 247(2)(b) of the ITA
• Section 247(2)(b) of the Canada ITA allows the
  CRA to re-characterize a transaction in
  situations where
• Related parties would not have entered into such
  transactions
• Related parties are getting a tax benefit

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Current CRA Audit Case Involving Low Tax
Jurisdiction

• The CRA is examining tax returns related to
  intercompany matters from 1998-2004 of a
  Pharmaceutical Company
• October 10, 2006, the CRA issued notice of
  assessment totaling 1.4 Billion, plus 360
  Million in interest
• Adjustments related to patent for its drug
• Drug was developed in Quebec and later
  transferred to Bermuda

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Tax Planning Opportunities

• Transfer pricing involves allocating profits
  based on the functions, assets and risks assumed
• Firms can optimize their after tax savings by
  strategically locating their functions, assets
  and risks in a manner that is acceptable to the
  governments involved

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Why Migrate Intangibles?

• To move potential profits to low tax
  jurisdictions such as Barbados
• Protection of intellectual property
• Capital Funding
• Sharing in intangible development risks
• Tax credit issues

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Migrating Intangibles

• Commonly used methods to migrate intangible
  assets include
• Sale of intangibles
• Cost-sharing agreements
• Buy-in payments

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Migrating Considerations

• The approach taken to migrating intangibles will
  depend on the stage of intangible development
• Three different stages include
• Existing intangibles
• Intangibles under development
• Acquired intangibles

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Opportunities for Migrating Intangibles

• Ideally, a multinational corporation should
  migrate its intangible assets well before those
  assets prove to be valuable
• Many companies consider migrating assets well
  after their value is realized

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Effects of Migrating Intangibles on Related
Parties

• Suppose a full fledged manufacturer migrates an
  intangible to a distributor operating in a
  different tax jurisdiction
• The manufacturer becomes less functionally
  intensive while the distributor becomes more
  functionally intensive

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Types of Manufacturers
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Types of Distributors
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Sale of Intangible Assets

• Sale must be at arms length prices
• Determining the arms length price of intangibles
  is complicated
• Related party transactions can be controversial
  with tax authorities
• Difficult to find comparable transactions
  acceptable to all parties involved

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Cost Sharing Agreement (CSA)

• A CSA is essentially an agreement between two
  parties that states the contributions each party
  will make and the benefits each will receive
• In order for a CSA to be effective, it must
• make business and economic sense
• include upfront and well-documented terms
• indicate the costs incurred by each party
  relative to the reasonability of expected
  profits and
• if providing entry, exit, or termination of a
  CSA, involve arms length prices 

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Documentation

• Documentation must illustrate that related party
  transactions, including those that involve
  intangible transfers, are done at fair market
  value
• The documentation must clearly lay out all
  relevant facts and place appropriate weight on
  the functions, assets and risks
• The IRS requires detailed documentation and may
  question the qualifications of the individuals
  preparing the documentation

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Advance Pricing Agreements

• Provides prospective avoidance of double taxation
• Replaces documentation and provides penalty
  protection
• Can be an efficient resolution to recurring
  complex transfer pricing issues
• Potential application of findings to past years

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Dispute Resolution Avenues

• Appeals
• Competent Authority
• Mutual Agreement Procedure
• Advance Pricing Agreements
• Arbitration

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Canadian Competent Authority

• Organization Chart
• Competent Authority Services Division (CASD)

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Competent Authority Process

• Notification to the Competent Authority
• Notification is the taxpayers responsibility
• Must have a tax treaty with the foreign country
• Using economists, CA will prepare a position
  paper which will be sent to the foreign
  government

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Competent Authority Process (contd)

• If agreed to by the foreign CA - adjustment
  processed
• Where there is disagreement, the case is
  negotiated
• Taxpayers can accept or reject the settlement and
  may appeal by filing a Notice of Objection

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Realities of the Competent Authority Process

• Many stakeholders are involved with varying
  interests
• CA can perform an economic evaluation
• CA can make downward changes to audit adjustments
• Materiality of the adjustment has an impact
• Most cases resolved without double taxation
• Files are not traded off against each other

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Factors Involved in Reaching a Negotiated
Settlement

• Quality of documentation
• Availability of economic data
• Transfer pricing is not an exact science
• Materiality of adjustments
• Similar facts and circumstances in other cases
• Policy decisions

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Transfer Pricing Review Committee Referrals

• Mandatory under certain conditions
• Not negotiable in Competent Authority
• Penalty is reviewed internally by the TPRC
• Representations can be made to the TPRC
• As of Aug 26/08
• 149 penalty referrals - penalty applied in 87
  cases
• 27 recharacterization referrals 6 assessed, 11
  dropped, 10 under review

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Advance Pricing Arrangements (APAs)

• An APA is a formal arrangement between the
  Minister of National Revenue and a Canadian
  taxpayer involved in cross-border transactions
  with a foreign related entity
• Bilateral APA (BAPA) or Multilateral APA (MAPA)
  is a formal arrangement entered into between the
  Canadian CA and its foreign counterpart under the
  MAP

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Waiver of Penalty on APA and Rollback

• A rollback will no longer be considered for
  Unilateral APAs
• The CRA has a concern that corresponding
  adjustments are not being made to the tax returns
  of non-residents in situations where downward
  adjustments are allowed in Canada

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Waiver of Penalty on APA and Rollback (contd)

• A rollback, requested as part of an APA, will no
  longer be considered for a taxation year where
  the CRA has issued a 90 day letter
• However, if a taxpayer requests a rollback before
  the 90 day letter has been issued, it is
  equivalent to a voluntary disclosure
• 
  
  
  
  
• Rationale rollback is not intended to replace an
  audit or as a mechanism for avoiding an audit

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Waiver of Penalty on APA and Rollback (contd)

• If a 90 day letter has not been issued, an
  auditor will not make a referral to the TPRC if
  an upward adjustment in a rollback year exceeds
  the penalty threshold
• This may create an incentive to apply for an APA
  in situations where contemporaneous documentation
  was not prepared for prior years as it reduces
  exposure to transfer pricing penalties that could
  come about in a random audit

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Other Issues The Fifth Protocol

• The Fifth protocol to the US-Canada treaty was
  signed on
• September 21, 2007
• Currently, Canadian Income Tax Act imposes a
  withholding tax of 25 on interest paid to a
  non-resident of Canada, unless an exemption
  applies or the rate is reduced under a tax treaty
• Protocol will eliminate withholding tax on all
  interest paid to arms length non-residents
• The exemption for unrelated party interest will
  be effective at the beginning of the second month
  following the month the protocol comes into force

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Other Issues The Fifth Protocol (contd)

• Non-arms length interest paid to U.S. qualifying
  person
• Phase out over three years
• 7 in first year, 4 in second year, 0 for third
  year
• Guarantee Fees to U.S. qualifying person
• Canadian transfer pricing requires borrower to
  pay arms length fee
• Unclear whether guarantee fees paid to non-arms
  length person would phase out with interest or
  not

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Conclusion

• Transfer pricing involves the price charged to a
  related foreign affiliate for goods, services
  and/or intangibles
• Governments around the world require that all
  cross-border transactions between related parties
  be documented
• Proper planning is acceptable and can help reduce
  a companys audit exposure and optimize the
  companys effective tax rate
• Intercompany charges for goods, services and/or
  intangibles must be well documented
• Taxpayers must ensure that their transfer pricing
  documentation can hold up to the scrutiny of tax
  authorities

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Thank You!
Presenters Dale C. Hill Partner, Tax
Services Tel [phone] E-mail
dale.hill_at_gowlings.com Gowling Lafleur
Henderson LLP, Transfer Pricing Competent
Authority Group 2600-160 Elgin Street, Ottawa,
Ontario, K1P 1C3