By Titus I. Deac
Illustration: Mike Constable
 THE ABSENCE OF PROPER DOCUMENTATION IN TRANSFER PRICING CAN MAKE A REVIEW A FRUSTRATING EXPERIENCE FOR ALL INVOLVED
In Ernst & Young's 2001 global survey on transfer pricing, 84% of participants reported their Canadian subsidiaries have transfer-pricing documentation prepared contemporaneously in accordance with the requirements of section 247 of the Income Tax Act. The same percentage of Canadian subsidiaries expected a transfer-pricing examination within the next two years. These findings appear to reverse the impression that many Canadian taxpayers prepare documentation so they can respond Yes on the T106 form, hoping to avoid a transfer-pricing audit.
The survey also portrays a sharp increase in transfer-pricing adjustments (more than 100% compared with 1999 survey results), which raises the question whether high levels of compliance with the documentation requirements help reduce the likelihood of a transfer-pricing adjustment. An increase in transfer-pricing audits and the possibility of adjustments were expected after the 1998 introduction of Canadian transfer-pricing legislation and the related significant increase in the Canada Customs and revenue Agency resources devoted to transfer pricing. Canadian legislation followed the implementation of new US transfer-pricing rules in the mid-'90s and the subsequent release of the Organization for Economic Co-operation and Development (OECD) transfer-pricing guidelines.
To some extent, the adjustments disclosed in the survey reflect the very deficiencies the new rules aimed to eliminate. Surprisingly, the sharp increase in transfer-pricing adjustments is contemporaneous with a high level of compliance with the new documentation standard. The documentation was expected to be an effective tool in asserting the arm's length principle and defending positions on audit, leading to a decrease in adjustments. Even considering the normal audit lag, these findings warrant a look at the documentation standard and a review of the extent to which compliant taxpayers are sheltered from the risk of penalty and from the risk of significant transfer-pricing adjustments.
The OECD endorses the government's right to obtain transfer-pricing documentation for verifying compliance with the arm's length principle. As transfer pricing is fact intensive, absence of proper documentation can make any review by the tax authorities a frustrating experience. The documentation required for transfer-pricing purposes represents an unprecedented level of detail about some of the most intimate aspects of the business, unparalleled by any other tax requirements. Under these circumstances, the reported level of compliance with the Canadian documentation requirements represents an impressive achievement for such a short period.
The transfer-pricing documentation provision of subsection 247(4) of the tax act is not an absolute obligation imposed on taxpayers. It is more an option given taxpayers to possibly avoid a significant penalty, otherwise arising as a consequence of large transfer-pricing adjustments, than a true compliance requirement. In effect, the act offers a deal to taxpayers: "Make a reasonable effort, including an audit trail, and we may make adjustments but we won't hit you with the penalty." That the "compliant documentation" is designed to help tax authorities is clear from its basic requirement –– a complete and accurate description of a list of items that go to the core of the business but may not add value for the taxpayer (compliant or Yes documentation and compliant taxpayer refer here to compliance with the contemporaneous documentation requirements listed in paragraphs (a) and (b) of subsection 247(4) of the act that entitles taxpayers to check the Yes box on form T-106).
The penalty documentation trade-off is still a good deal if preparing it protects taxpayers and expedites the audit process. However, incomplete or advocacy documentation may not sufficiently protect taxpayers nor lead to an efficient audit.
How documentation is linked to the arm's length standard is not straightforward. In some cases, this results in the standard not being met so adjustments may arise despite the existence of what is believed to be penalty compliant documentation. Another problem is the vague "reasonable efforts" test. Only a certain level of documentation effort that meets this test is effective as a penalty shelter. To simplify the process, the compliant documentation asks taxpayers to document what they actually do; instead, the reasonable efforts require taxpayers to document what they should do (take steps to determine and use arm's length transfer prices).
The difficulty with this subjective criterion is twofold: first, there is no clear requirement to determine, use and document arm's length prices in order to check the Yes box on form T-106 — arguably a minimum level of documentation will meet this requirement. Second, "reasonable efforts" is neither defined in the act nor sufficiently clarified administratively, which creates confusion. So, what is accomplished by checking the Yes box? As a minimum, taxpayers will not be listed as noncompliant; at best, the penalty will not apply in the event of an adjustment. However, merely checking the box does not guarantee compliance with the arm's length standard nor with the reasonable efforts test.
The fact that Yes documentation may not reach the level of arm's length prices does not prevent the CCRA from getting there. Its auditors are becoming more sophisticated and can resort to secret comparables as well as analysis performed by other taxpayers with similar transfer-pricing issues. As the CCRA is able to build databases of transfer-pricing analysis and benchmarks in all industries, better analysis will be used to challenge weaker analysis in similar fact circumstances.
As the post-1998 audit cycle is still underway, it is difficult to predict how the reasonable efforts standard will apply in practice — will the mere existence of Yes type documentation suffice to avoid the penalty or is there a higher standard? In this early phase of implementation, the CCRA may show lenience regarding this test, while aggressively pursuing the arm's length standard, as reflected in the sharp increase in transfer-pricing adjustments.
Documentation that doesn't meet the reasonable efforts test may aid the CCRA in the performance of its audits without effectively protecting many taxpayers from adjustment or penalty. There's a possibility a large segment of Canadian firms with Yes documentation are in this area.
It is a question of fact whether documentation that meets the reasonable efforts test brings an important benefit to taxpayers. This is the case only where meeting the test leads effectively to a significantly reduced risk of adjustments. Only documentation demonstrating compliance with the arm's length standard truly helps taxpayers. When 84% of Canadian companies will have arm's length documentation, the likelihood of transfer-pricing adjustments will certainly decrease, not increase, as it is now the case.
Confronted with this high incidence of transfer-pricing adjustments, taxpayers have three basic options: the first is to follow the penalty-driven approach to documentation designed by the transfer-pricing legislation and encouraged by the administrative practice — for example, to prepare compliant documentation that would entitle the taxpayer to check the Yes box on the T-106. Internal comparables (prices, margins, mark-ups) are of great importance not only because they bench-mark arm's length prices but also because they are not expensive or difficult to determine. By following this option, taxpayers with minor transfer-pricing issues could be safe from both application of the penalty and significant transfer-pricing adjustments. For taxpayers with more complex issues, this approach may save some costs upfront but not be cost effective in the long term, as an expensive transfer-pricing adjustment, plus interest could apply.
A second option is to prepare solid transfer-pricing documentation aimed at minimizing or eliminating the risk of a significant transfer-pricing adjustment. This, in turn, guarantees that the penalty would not apply. This approach may be more expensive but cost effective in the long run, saving taxpayers significant amounts and providing a higher level of compliance with the arm's length standard. This option is for businesses with a transfer-pricing problem from a tax perspective or from a business perspective.
In light of the increase in transfer pricing adjustments, it is recommended companies expecting a transfer-pricing audit review their documentation. In the case of complex intercompany transactions, the documentation could be guided directly by the statutory criteria for transfer-pricing adjustments — a close, objective comparison with arm's length terms and conditions, based on benchmarking, as opposed to the vague, subjective reasonable efforts test.
Similar to the reasonable efforts test, there is no standard guidance as to what proper documentation is. The main difference between the two options is that what constitutes reasonable efforts is at the CCRA's judgment, what constitutes proper transfer-pricing policies is at the taxpayers' discretion.
The third option could be a bilateral or multilateral advance transfer-pricing agreement. This may be appropriate in cases where a significant transfer-pricing problem has already been identified, like a history of audit difficulties, differences in the approach of other tax administrators to certain transfer-pricing issues or simply a case where a higher level of certainty is required.
What makes this option unique in the Canadian transfer-pricing environment is that, despite CCRA's auditors' aggressiveness in scrutinizing transfer-pricing arrangements, in the case of APAs, the CCRA is seen by many taxpayers as helping the Canadian multinational by negotiating an acceptable deal with other tax authorities.
Titus I. Deac is senior manager transfer pricing with Ernst & Young in Vancouver.
Technical Editor: Michel Lanteigne, FCA, Managing Partner Tax for Canada, Ernst & Young, LLP | 
