Group taxation is not permitted.
Canadian transfer pricing legislation and administrative guidelines are generally consistent with the OECD Guidelines. Statutory rules require that transactions between related parties be carried out under arm's-length terms and conditions. The CRA has indicated that it will apply the revised OECD guidance on transfer pricing by MNEs (published January 2022), arising from the base erosion and profit shifting (BEPS) project (the BEPS final report was issued October 2015; see Base erosion and profit shifting [BEPS] in the Tax administration section for more information). The government’s view is that the revised guidance is generally consistent with the CRA’s interpretation and application of the arm’s-length principle and that, consequently, CRA audit practices are not expected to change significantly.
On 26 September 2018, the Tax Court of Canada (TCC) issued its decision on a transfer pricing court case involving Cameco Corporation. The decision provides important guidance on the application of Canada’s transfer pricing recharacterisation rules, the use of hindsight in determining transfer prices, and the significance of contractual terms; and some insight can be inferred for their implications relating to transfer pricing documentation. Certain principles that were set out in the TCC decision are already proliferating current dialogue in the Canadian transfer pricing landscape. On 26 June 2020, the Federal Court of Appeal (FCA) upheld the TCC's decision, and, on 18 February 2021, the Supreme Court of Canada (SCC) denied the Crown's application for leave to appeal this decision to the SCC. Following this denial, the 2021 federal budget announced the government's intention to consult on changing the transfer pricing legislation to consider the FCA's decision. The government is concerned that perceived shortcomings in the current transfer pricing rules may encourage the inappropriate shifting of corporate income out of Canada and intends to update the legislation, with a view to protecting the integrity of the tax system while preserving Canada's attractiveness as a destination for new investment and business activity. The 2022 federal budget confirmed the government’s intention to proceed with Canada’s transfer pricing rules consultation announced in the 2021 federal budget. The consultation paper is yet to be released.
Penalties may be imposed on adjustments to income if the taxpayer has been found not to have made reasonable efforts or is deemed not to have made reasonable efforts to determine and use arm’s length prices. A taxpayer will be deemed not to have made reasonable efforts if the taxpayer does not maintain contemporaneous documentation for its related party transactions that is complete and accurate in all material respects with regards to the criteria set out in the legislation. The documentation must be prepared on or before the taxpayer's documentation due date, which is six months after the end of the taxation year for corporations.
The transfer pricing penalty is 10% of the transfer pricing adjustment if the adjustment exceeds the lesser of CAD 5 million and 10% of the taxpayer's gross revenue for the year. The penalty is not deductible in computing income, applies regardless of whether the taxpayer is taxable in the year, and is in addition to any additional tax and related interest penalties.
Canada has an Advance Pricing Arrangement (APA) program that is intended to help taxpayers obtain a level of certainty on transfer prices acceptable to the local tax authorities and, when negotiated as bilateral or multilateral APAs, with tax authorities in other jurisdictions.
Many of Canada's international tax agreements contain provisions concerning income allocation in accordance with the arm's-length principle. These include a Mutual Agreement Procedure, which is a treaty-based mechanism through which taxpayers can petition competent authorities for relief from double taxation resulting from transfer pricing adjustments. The OECD's Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (also known as the Multilateral Instrument [the MLI]) entered into force for Canada on 1 December 2019 and applies to some of Canada's tax treaties as early as 1 January 2020 (see Treaty shopping in the Tax administration section for more information).
Transfer pricing adjustments
When the Canadian transfer pricing rules have applied to adjust, for tax purposes, amounts related to transactions between a Canadian corporation and one or more non-arm’s length non-residents (a ‘primary adjustment’), the related benefit to the non-residents is treated by the CRA as a deemed dividend (a ‘secondary adjustment’), subject to WHT, which can be eliminated, at the discretion of the Minister of Revenue, if the amount of the primary transfer pricing adjustment is repatriated to the Canadian corporation.
For taxation years beginning after 18 March 2019, an ordering rule clarifies that adjustments resulting from the transfer pricing rules must be made before applying any other provisions of the Income Tax Act. This ordering could affect the determination of penalties under the transfer pricing rules, but it does not affect the existing exemption from the transfer pricing rules for certain loans and guarantees provided by Canadian-resident corporations to controlled foreign affiliates.
Downward transfer pricing adjustment requests involving a country with which Canada has a tax treaty must be reviewed by the Canadian competent authority under the mutual agreement procedures. Downward adjustment requests involving non‑treaty countries should also be referred to the Canadian competent authority for review.
Country-by-country (CbC) reporting
Annual CbC reporting is required for MNEs with total annual consolidated group revenue of EUR 750 million or more (approximately CAD 1 billion). The reporting includes key metrics for each country the MNE operates in, such as: revenue, profit, tax paid, stated capital, accumulated earnings, number of employees, and tangible assets, as well as a description of the main activities of each of its subsidiaries. The reporting is due within one year of the end of the fiscal year to which the report relates.
Form RC4649 ‘Country-by-Country Report’ is the CRA's reporting form that follows the CbC reporting format recommended by the OECD in its October 2015 BEPS report on transfer pricing documentation and CbC reporting. Publication RC4651 (E) ‘Guidance on Country-By-Country Reporting in Canada' provides further guidance that is generally consistent with the OECD’s recommendations, but includes several differences.
To facilitate the sharing of this information with its international treaty partners, Canada, along with many other jurisdictions, has signed the OECD’s Multilateral Competent Authority Agreement on CbC reporting. The first exchanges between jurisdictions of CbC reports occurred in July 2018. Before any such exchanges, the CRA will have formalised an exchange arrangement with the other jurisdiction and ensured that appropriate safeguards are in place to protect the confidentiality of the reports.
It is important to determine a Canadian entity’s CbC report filing obligation by identifying whether Canada has a qualified competent authority agreement with a particular country for purposes of exchanging CbC reports. If this agreement does not exist, a Canadian MNE must file a CbC report in Canada as a constituent entity, even if a CbC report has been prepared and filed by an ultimate parent entity or a surrogate parent entity in that particular country.
Canada and the United States have signed a bilateral competent authority arrangement to allow for the exchange of CbC reports. The reports should be exchanged no later than 15 months after the year end of an MNE group.
Thin capitalisation rules can limit interest deductions when interest-bearing debt owing to certain non-residents (or persons not dealing at arm's length with certain non-residents) exceeds one and a half times the corporation’s equity. The rules also apply to debts owing by:
- a partnership of which a Canadian-resident corporation is a member
- Canadian-resident trusts, and
- non-resident corporations and trusts that operate in Canada.
Disallowed interest is treated as a dividend paid to the non-residents and subject to WHT.
Interest deductibility limits
Draft legislative proposals introduce interest limitation rules that are consistent with the recommendations in the BEPS Action Plan (Action 4). The proposed new rules are expected to take effect for taxation years beginning after 30 September 2023 and will limit the amount of net interest and financing expenses that a corporation (and a trust, partnership, or Canadian branch of a non-resident taxpayer) may deduct in computing its taxable income to no more than the following fixed ratio of its ‘tax EBITDA’ (taxable income before interest expense, interest income, income tax, and deductions for depreciation and amortisation, as determined for income tax purposes):
- 40% for taxation years beginning after 30 September 2023 and before 2024, and
- 30% for taxation years beginning after 2023.
A ‘group ratio’ rule will allow a taxpayer to deduct interest in excess of the fixed ratio, where the taxpayer can demonstrate that the ratio of net third party interest to book EBITDA of its consolidated group is higher than the fixed ratio; in this case, the interest limitation would be based on the higher group ratio if the Canadian members of a group of corporations and/or trusts jointly elect into the regime with respect to the relevant taxation year..
Denied interest can be carried back 3 years, or carried forward indefinitely. Exemptions are available for:
- CCPCs whose associated group has taxable capital employed in Canada of less than CAD 50 million,
- groups of corporations and trusts whose aggregate net interest expense among their Canadian members is CAD 1 million or less, and
- certain Canadian-resident corporations and trusts that carry on substantially all of their business in Canada and have minimal investments in foreign subsidiaries, provided certain conditions are met.
Back-to-back loan arrangements
The Canadian Income Tax Act contains ‘back-to-back loan’ rules that prevent taxpayers from interposing a third party between a Canadian borrower and a foreign lender to avoid the application of rules that would otherwise apply if a loan were made directly between the two taxpayers. The back-to-back loan rules ensure that the amount of WHT on a cross-border interest payment cannot be reduced through the use of back-to-back loan arrangements. Anti-avoidance provisions also apply to certain back-to-back loan arrangements undertaken by taxpayers using an interposed third party:
- in the thin capitalisation rules, and
- relating to WHT on interest payments.
In addition, these back-to-back loan rules:
- apply to cross-border payments of rents, royalties, or similar payments (an exception is available for certain arm’s-length royalty arrangements that do not have a main purpose of avoiding WHT)
- include character substitution rules so the back-to-back loan rules cannot be avoided through the substitution of economically similar arrangements between the intermediary and another non-resident person, for interest and royalty payments
- apply to back-to-back shareholder loan arrangements (if there are multiple intermediaries), and
- apply to back-to-back arrangements involving multiple intermediaries, for interest and royalty payments, and for shareholder debts.
Hybrid mismatch arrangements
Hybrid mismatch arrangements are cross-border transactions that are characterised differently under the tax laws of different countries. For example, certain financial instruments may be treated as debt in one country and equity in another country. Hybrid mismatches can also involve certain entities that are treated as separate taxpayers in one country but are treated as fiscally transparent in another country. Draft legislative proposals (the first of two legislative packages) implement rules to eliminate the tax benefits arising from hybrid mismatch arrangements; the federal proposals are generally consistent with the recommendations of the BEPS Action Plan (Action 2) (with modifications for the Canadian income tax context).
The first package of draft legislative proposals deals with ‘deduction/non-inclusion’ mismatches relating to three types of hybrid mismatch arrangements (including mismatches involving hybrid transfers of financial instruments and substitute payments relating to these instruments). Generally, these hybrid mismatches involve situations in which a payment relating to a financial instrument is deductible by the payer and is not included in the ordinary income of the recipient. For payments generally arising after 30 June 2022, the draft legislative proposals require taxpayers to work through a series of tests to determine whether the rules would apply to particular arrangements, and, if so, the following rules apply:
- Primary Rule: a payment by a Canadian resident under a hybrid mismatch arrangement will not be deductible in Canada to the extent that it is not included in the ordinary income of a non-resident recipient.
- Secondary Rule: a payment made by a non-resident to a Canadian resident under a hybrid mismatch arrangement will be included in ordinary income of the Canadian recipient to the extent the payment is deductible in another country (if the payment is a dividend from a foreign affiliate, no offsetting deduction will be available under the normal rules for foreign affiliate dividends).
The proposed rules are intended to align with the recommendations of the Action 2 Report and to be interpreted based on that report (except where the context otherwise requires). However, this first package of legislation contains notable deviations from the Action 2 Report, including:
- treating interest payments that are non-deductible under these rules as deemed dividends for withholding tax purposes
- applying the rules to arrangements involving notional interest deductions (when no interest is actually paid)
Denial of Foreign affiliate dividend deductions
In addition to the main operative rules outlined above, the proposals include a new restriction on the deductions for certain dividends received from foreign affiliates. The new rule denies access to a deduction for a foreign affiliate dividend, to the extent the dividend is deductible for foreign tax purposes by the dividend payer (or by certain other entities that pick-up the dividend payer’s income for foreign tax purposes). Unlike the main operative rules, the application of this rule does not require a hybrid mismatch arrangement.
A targeted anti-avoidance rule addresses certain arrangements that produce outcomes substantially similar to those caught by the proposed rules, but which do not satisfy the technical requirements of those rules.
The proposed rules will apply to payments arising after 30 June 2022 (for these purposes, this can include amounts paid or accruing after 30 June 2022).
A second package of draft legislative proposals, which will implement the remaining recommendations in the Action 2 Report, to the extent they are relevant in the Canadian context, is expected to be released at a later date and to apply no earlier than 2023.
Hedging and short-selling by financial institutions
To curtail the creation of artificial tax deductions in a financial institution group that involves the ownership of Canadian shares on which tax-free dividends are received and then entering into an SLA and short sell arrangement on these shares to qualify for dividend compensation payment deductions, draft legislative proposals:
- deny a deduction for dividends received by a taxpayer on Canadian shares, if a registered securities dealer that does not deal at arm’s length with the taxpayer enters into transactions that hedge the taxpayer’s economic exposure to the Canadian shares, where the registered securities dealer knew or ought to have known that these transactions would have such an effect
- deny a dividend deduction for dividends received by a registered securities dealer on Canadian shares it holds, if it entered into hedging transactions to eliminate all or substantially all of its economic exposure to the Canadian shares
- provide that, when the dividend deduction is denied in these situations the securities dealer will be permitted to claim a full (instead of two-thirds) deduction for a dividend compensation payment it makes under an SLA entered into in connect with the related hedging transactions
These measures would apply to dividends and related dividend compensation payments that are paid or become payable after 6 April 2022 (if the relevant arrangements were in place before 7 April 2022, the measures would apply after September 2022).
Controlled foreign affiliates and foreign accrual property income (FAPI)
Under Canada’s FAPI rules, Canadian corporations are taxed on certain income of controlled foreign affiliates (typically, certain income from property, income from a business other than active, income from a non-qualifying business, and certain taxable capital gains) as earned, whether or not distributed. A grossed-up deduction is available for foreign income or profits taxes and WHTs paid in respect thereof. In general, a foreign corporation is a foreign affiliate of a Canadian corporation if:
- the Canadian corporation owns, directly or indirectly, at least 1% of any class of the outstanding shares of the foreign corporation, and
- the Canadian corporation, alone or together with related persons, owns, directly or indirectly, at least 10% of any class of the outstanding shares of that foreign corporation.
The foreign affiliate will be a controlled foreign affiliate of the Canadian corporation if certain conditions are met (e.g. more than 50% of the voting shares are owned, directly or indirectly, by a combination of the Canadian corporation, persons at non-arm’s length with the Canadian corporation, a limited number of Canadian-resident shareholders, and persons at non-arm’s length with those Canadian-resident shareholders).
Income from an ‘investment business’ of a foreign affiliate is generally included in its FAPI. When the income attributable to specific activities carried out by a foreign affiliate accrues to a specific Canadian taxpayer under a tracking arrangement, such activities are deemed to be a separate business. Each separate business will need to meet specific conditions, including the ‘six employees’ test, to be excluded from the investment business definition.
When the principal purpose of a business carried on by an affiliate is to derive income from trading or dealing in indebtedness, the income from that business is generally included in its FAPI. Certain minimum capital requirements apply to the trading or dealing in indebtedness rules for an affiliate to qualify for the regulated foreign financial institution exception.
Controlled foreign affiliate status
A foreign affiliate of a taxpayer is deemed to be a controlled foreign affiliate of the taxpayer if FAPI attributable to specific activities of the foreign affiliate accrues to the benefit of the taxpayer under a tracking arrangement.