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Transfer pricing taxation : Canadian perspective and Japanese perspective Nakayama, Kiyoshi 1987

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TRANSFER PRICING TAXATION CANADIAN PERSPECTIVE AND JAPANESE PERSPECTIVE by KIYOSHI NAKAYAMA LL.B., KOBE UNIVERSITY, 1981 A THESIS SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF LAWS i n THE FACULTY OF GRADUATE STUDIES (Faculty of Law) We accept t h i s thesis as conforming to the required standards THE UNIVERSITY OF BRITISH COLUMBIA MAY 1987 © Kiyoshi Nakayama, 1987 In presenting this thesis in partial fulfilment of the requirements for an advanced degree at the University of British Columbia, I agree that the Library shall make it freely available for reference and study. I further agree that permission for extensive copying of this thesis for scholarly purposes may be granted by the head of my department or by his or her representatives. It is understood that copying or publication of this thesis for financial gain shall not be allowed without my written permission. Department of Law  The University of British Columbia 1956 Main Mall Vancouver, Canada V6T 1Y3 Date J u n e 22, 1987 DE-6(3/81) ( i i ) ABSTRACT For t h e l a s t decades, t r a n s f e r p r i c i n g has been one of the most important i s s u e s f o r both t a x a u t h o r i t i e s and m u l t i n a t i o n a l c o r p o r a t i o n s . On the one hand, t a x a u t h o r i t i e s , d e s p i t e t h e i r counter-measures, have not been a b l e t o cope w i t h i n t e r n a t i o n a l t a x avoidance o r e v a s i o n u s i n g t r a n s f e r p r i c i n g by m u l t i n a t i o n a l c o r p o r a t i o n s owing t o the d e f i c i e n c y o f t a x systems and the i n a b i l i t y o f t a x a d m i n i s t r a t i o n s and t h i s has r e s u l t e d i n a huge revenue l o s s t o the c o f f e r s o f t h e i r c o u n t r i e s . On the o t h e r hand, w h i l e m u l t i n a t i o n a l c o r p o r a t i o n s have been u s i n g t r a n s f e r p r i c i n g as v e h i c l e s t o maximize t h e i r o v e r a l l a f t e r - t a x p r o f i t s as a group, they have been s u f f e r i n g i n t o l e r -a b l e a d m i n i s t r a t i v e burdens and double t a x a t i o n caused by enforcement o f counter-measures by t a x a u t h o r i t i e s . The b a s i c p r i n c i p l e f o r t r a n s f e r p r i c i n g t a x a t i o n l e g i s l a -t i o n i s the "arm's l e n g t h p r i n c i p l e " , t h a t t r a n s a c t i o n s between p a r t i e s t h a t are not d e a l i n g a t arm's l e n g t h should be c a r r i e d out f o r t a x purposes under terms and a t a p r i c e t h a t one c o u l d r e a s o n a b l y have expected i n s i m i l a r circumstance had t h e p a r t i e s been d e a l i n g a t arm's l e n g t h . T h i s p r i n c i p l e has been endorsed by the OECD, Canada, the U.S. and ot h e r developed c o u n t r i e s , however, common s p e c i f i c g u i d e l i n e s under t h i s p r i n c i p l e have not been established among tax authorities and even multinational corporations themselves cannot always f i n d an arm's length p r i c e acceptable to tax a u t h o r i t i e s . Since the OECD Committee on F i s c a l A f f a i r s issued the report "Transfer P r i c i n g and Multinational Enterprises" i n 1979, tax a u t h o r i t i e s , multinational corporations and tax p r a c t i t i o n e r s have been making strenuous e f f o r t s to f i n d a reasonable and p r a c t i c a l transfer p r i c i n g taxation system and to coordinate i t s enforcement, a l l of which enables tax a u t h o r i t i e s to recover or keep t h e i r f a i r share of revenue and protect multinational corporations from double taxation. At present, the s i t u a t i o n already shows some improvements due to e f f o r t s for the harmonization of guidelines among tax a u t h o r i t i e s , and due to multinational corporations' a p p l i c a t ion of t r a n s f e r p r i c i n g p o l i c y i n a more s e l f - r e s t r i c t e d manner, and more appropriate advice from tax p r a c t i t i o n e r s . However, there i s s t i l l room for possible improvements. In Canada, there have been no guidelines other than the Income Tax Act which provides general p r i n c i p l e s of transfer p r i c i n g taxation, and actual enforcement has been based on the i n t e r n a l assessing guideline of Revenue Canada. But, on February 27, 1987 Revenue Canada issued Information C i r c u l a r 87-2. Although an information c i r c u l a r does not carry any l e g a l weight, i t i s expected that the c i r c u l a r w i l l eliminate taxpayers' uncertainty and augment tax compliance. On the other hand, i n Japan, despite i t s export-oriented ( i v ) economy, the Japanese tax aut h o r i t i e s have not been keeping pace with the i n t e r n a t i o n a l i z a t i o n of economic a c t i v i t i e s . Having introduced anti-tax haven l e g i s l a t i o n i n 1978, Japan i n 1986 introduced transfer p r i c i n g taxation l e g i s l a t i o n . Although f a i r l y concrete p r i c i n g methods have been written into l e g i s l a -t i o n i n order to permit the reasonable enforcement of the new system, there i s much to be learned from the experience of the "advanced" countries. Above a l l , Canada's experience could be useful, as the provisions of the new Japanese transfer p r i c i n g taxation l e g i s l a t i o n are s i m i l a r to those of the Canadian Income Tax Act and both countries have several s i m i l a r i t i e s i n terms of t h e i r r e l a t i o n s h i p with the U.S. In t h i s t h esis, a f t e r reviewing the background to these problems, I w i l l discuss the Canadian tr a n s f e r p r i c i n g taxation system and i t s enforcement by looking at each type of intra-group transaction and the corresponding adjustment and mutual agreement procedure system. Then I w i l l compare the Canadian approach and Japanese approach. Possible improvements w i l l be dealt with i n the conclusion. Since there has been l i t t l e jurisprudence i n t h i s area, the discussions are primarily based on the tax a u t h o r i t i e s ' perspec-t i v e s and the OECD reports. ( V ) T A B L E O F CONTENTS Page CHAPTER I INTRODUCTION 1 1. BACKGROUND 1 2. THE PROBLEMS WHICH TAX AUTHORITIES ARE FACING AND THEIR COUNTERMEASURES 5 3. THE PROBLEMS WHICH MULTINATIONAL CORPORATIONS ARE FACING 7 CHAPTER II THE CANADIAN TRANSFER PRICING TAXATION SYSTEM 11 SUBCHAPTER I OUTLINE OF THE CANADIAN TRANSFER PRICING TAXATION SYSTEM 11 1. LEGISLATION 11 2. ARM'S LENGTH PRINCIPLE 15 SUBCHAPTER II TRANSFER OF GOODS 24 1. COMPARABLE UNCONTROLLED PRICE METHOD 24 2. RESALE PRICE METHOD 29 3. COST PLUS METHOD 33 4. OTHER METHODS AND GENERAL CONSIDERATIONS 36 SUBCHAPTER III PROVISION OF INTRA-GROUP SERVICES 50 1. INTRODUCTION 50 2. JUSTIFICATION OF BENEFITS 51 3. METHOD OF ALLOCATION AND APPORTIONMENT 57 4. AMOUNT OF CONSIDERATION 64 5. SUMMING UP 66 SUBCHAPTER IV TRANSFER OF TECHNOLOGY 74 1. INTRODUCTION 74 2. LICENSING AGREEMENTS 76 3. COST CONTRIBUTION ARRANGEMENTS FOR R & D EXPENDITURE AMONG MEMBER COMPANIES OF MNCS 83 SUBCHAPTER V CORRESPONDING ADJUSTMENT AND MUTUAL AGREEMENT PROCEDURE 95 1. INTRODUCTION. 95 2. CORRESPONDING ADJUSTMENT 96 3. MUTUAL AGREEMENT PROCEDURE 100 4. SPECIFIC PROCEDURES TO BE TAKEN BY REVENUE CANADA AND CANADIAN TAXPAYERS IN THE MUTUAL AGREEMENT PROCEDURE 115 ( v i ) 5. SUMMING UP 122 CHAPTER III THE JAPANESE NEW TRANSFER PRICING TAXATION SYSTEM 129 1. BACKGROUND 129 2. OVERVIEW OF THE SYSTEM 130 3. ADMINISTRATIVE PRINCIPLES AND GUIDELINES 147 4. COMPARISON OF THE JAPANESE SYSTEM AND CANADIAN SYSTEM 153 CHAPTER IV CONCLUSION 165 1. INTRODUCTION 165 2. POSSIBLE IMPROVEMENTS 166 3. KEY CONSIDERATIONS TO BE GIVEN 184 4. FINAL REMARKS 189 SELECTED BIBLIOGRAPHY 193 (vii) ACKNOWLEDGEMENT This t h e s i s could not have been completed without the warm-hearted encouragement and expert guidance of Professor M. J. O'Keefe. I am much obliged to Professor M. Smith, the former Director of the Japanese Legal Studies, Professor M. T. MacCrimmon, Professor H. Kaneko, Tokyo University and Mr. Y. Gomi, the former Deputy Commissioner of the National Tax Administration for giving me an opportunity for studying at the University of B r i t i s h Columbia. I also wish to thank Revenue Canada, Taxation for allowing me to make researches at the Head O f f i c e and attend the seminars at Vancouver D i s t r i c t O f f i c e . F i n a l l y , I am g r a t e f u l to the University of B r i t i s h Columbia for i t s f i n a n c i a l assistance and the s t a f f of the Faculty of Law at the University of B r i t i s h Columbia. To them I express my hearty gratitude. 1 CHAPTER I INTRODUCTION 1. BACKGROUND As a consequence of the rapid i n t e r n a t i o n a l i z a t i o n of economic a c t i v i t i e s , the so-called "multinational corporations" have become powerful economic e n t i t i e s . A multinational corporation can be defined as a group of companies, which are l e g a l l y autonomous but i n t e r r e l a t e d , operating across national borders. 1 In a multinational corporation ("MNC"), many transactions take place between members of the group. A large amount of goods may be shipped from producing subsidiaries to s e l l i n g s u b s i d i a r i e s abroad, and i n v e r t i c a l l y integrated MNCs, some member companies only manufacture components or i n t e r -mediates which w i l l be assembled or further processed by another 2 member of the group. I t can be said that i n t e r n a l i z a t i o n and i n t e r n a t i o n a l i z a t i o n are the main features of MNC transactions. Such intra-group transactions are, more or le s s controlled by a parent company. And MNCs are i n a p o s i t i o n to adopt any measure, which w i l l allow them to conform to relevant national laws, whenever such a measure would benefit them. Since i t i s of v i t a l importance f o r MNCs to maximize t h e i r o v e r a l l after-tax p r o f i t s as a group, the tra n s f e r p r i c i n g , which can be defined as the p r i c i n g arrangement i n intra-group transactions has been an 2 3 i n t e g r a l part of MNCs1 tax planning. That i s to say, MNCs may f i x the p r i c e s i n t h e i r intra-group transactions against the i n t e r e s t s of the i n d i v i d u a l member companies at the d i s c r e t i o n of the parent company i f t h e i r o v e r a l l after-tax p r o f i t i s increased. In addition to the MNCs1 a b i l i t y to manipulate t r a n s f e r p r i c e s , there are a number of inducements to make such a p r i c e manipulation. F i r s t , d i f f e r e n t rates of corporate taxes may contribute to maximize after-tax p r o f i t s of MNCs. For example, i f the corporate tax rate i n Country A i s higher than that i n Country B, assuming other circumstances are equal, a MNC can increase i t s o v e r a l l after-tax p r o f i t s by underpricing the sales by i t s subsidiary i n Country A to i t s other subsidiary i n Country B. Even i f the tax rates are the same, as long as differences i n tax laws such as an accelerative depreciation, investment tax c r e d i t , etc. e x i s t , there would s t i l l be inducements. Above a l l , when the transaction takes place with s u b s i d i a r i e s i n tax haven countries, the transfer p r i c i n g scheme becomes even more tempting. Second, i n order to avoid withholding taxes i n the host country, MNCs may manipulate t h e i r transfer p r i c e s to reduce the payments which would be subject to the withholding tax. For example, to avoid the withholding tax on dividends, the parent company could reduce the p r o f i t of the subsidiary and dividends therefrom by overpricing the sale to the subsidiary. Or, i f the relevant tax treaty exempts the withholding tax on management 5 fees, MNCs disguise other payments as management fees. 3 Third, custom duties might make MNCs manipulate the transfer p r i c e s . Developing countries usually impose high import duties on f i n i s h e d goods, and to avoid such high import duties the parent company may underprice the sales to i t s subsidiary i n the country imposing high import d u t i e s . 6 Fourth, where MNCs su f f e r from r e s t r i c t i o n s on p r o f i t remittances i n a p a r t i c u l a r country, they may circumvent t h i s r e s t r i c t i o n by overpricing the sales to the subsidiary i n that 7 country. In addition to the above-mentioned inducements, transfer p r i c i n g could be used for the following purposes: to keep or augment a MNCs1 share of p r o f i t s i n a j o i n t venture by reducing the p r o f i t s of the j o i n t venture through overpricing by the parent company to the j o i n t venture; to deter labor demands for wage rai s e s i n a subsidiary by decreasing the p r o f i t s of the subsidiary; to compensate the "country r i s k " , i . e . to get fast returns on investment or to pay out c a p i t a l where the host country i s p o l i t i c a l l y unstable or tends to nationalize foreign corporations; to finance foreign s u b s i d i a r i e s ; to support an infant subsidiary; to f a c i l i t a t e penetration i n new markets; and, o to avoid exchange controls. On the other hand, there are several constraints on MNCs' a b i l i t i e s to manipulate transfer p r i c e s . In addition to countermeasures taken by tax aut h o r i t i e s , the following constraints which are int e r n a l to MNCs themselves may e x i s t . F i r s t , i n most MNCs the decentralized organizaton i s necessary f o r e f f e c t i v e management and subsidiaries are 4 9 established as autonomous p r o f i t centers. Where the " p r o f i t center" concept i s adopted by a MNC, since the p r o f i t performance of each subsidiary i s assessed on the basis of the p r o f i t s achieved i t s e l f , l o c a l managers are l i k e l y to r e s i s t transfer p r i c i n g manipulation which might reduce the p r o f i t s of the subsidiary unless the parent company keeps another set of accounts which records the r e a l p r o f i t performance of the s u b s i d i a r y . 1 0 Second, the costs of manipulating tr a n s f e r prices are expensive f o r MNCs; for example, such manipulation would require a large amount of central planning and decision making which might be counter-productive. 1 1 Third, the above-mentioned inducements c o n f l i c t with each other. For example, where a parent company overprices the goods sold to i t s foreign subsidiary i n order to avoid the r e s t r i c t i o n on p r o f i t r e p a t r i a t i o n by the host country of the subsidiary, t h i s manipulation may increase the p r o f i t s of the parent company 12 and also increase the import duties of the subsidiary. Considering these constraints, i t cannot be said that MNCs have unmitigated "freedom" to manipulate tr a n s f e r p r i c e s . MNCs have to antic i p a t e some disadvantages when they manipulate t r a n s f e r p r i c e s f o r p a r t i c u l a r tax purposes. The decision on whether or not, or how to manipulate must depend on the order of p r i o r i t y of the objects which the MNC wants to pursue. 5 2. THE PROBLEMS WHICH TAX AUTHORITIES ARE FACING AND  THEIR COUNTERMEASURES Although MNCs cannot always manipulate t r a n s f e r prices as they want because of various constraints, i t has to be recognized that MNCs have been successful i n minimizing t h e i r o v e r a l l tax burden at the expense of the developed countries. In other words, the c o f f e r s of the developed countries have been losing t h e i r f a i r share of revenue owing to MNCs1 tax planning. The p r o l i f e r a t i o n of "paper" companies i n tax haven countries indicates how easy and tempting i t i s f o r MNCs to s h i f t t h e i r taxable p r o f i t s into the tax haven subsidiaries by using the t r a n s f e r p r i c i n g schemes. To cope with such international tax avoidance or evasion by MNCs, tax a u t h o r i t i e s have introduced several l e g i s l a t i v e and administrative counter-measures. The "transfer p r i c i n g taxation system" i s thought to be the most e f f e c t i v e measure. The d e t a i l s of t h i s system depend on the s p e c i f i c l e g i s l a t i o n of each country, however, generally speaking, t h i s system can be defined as follows: Where the i n t e r n a l p r i c e i n an intra-group transaction of a MNC d i f f e r s from the p r i c e which would have been agreed upon between unrelated p a r t i e s engaged i n the same or s i m i l a r circumstances ("arm's length p r i c e " ) , the relevant tax a u t h o r i t i e s can adjust the actual p r i c e of the transaction, based on the arm's length p r i c e , or d i s t r i b u t e , apportion or al l o c a t e gross income, deductions or c r e d i t s among the members of the MNC. 6 Among the developed countries, the U.S. has been the most advanced country i n t h i s area. Although the U.S. introduced t r a n s f e r p r i c i n g taxation l e g i s l a t i o n , which i s equivalent to Section 482 of the present U.S. Internal Revenue Code ("IRC"), i n 1928, the Internal Revenue Service ("IRS") has not used t h i s weapon fo r a long time. However, a f t e r the Income Tax Regulation ("IRC Regulation"), which provides the methods f o r c a l c u l a t i n g arm's length prices, was enacted i n 1968, the IRS began rather intensive and aggressive enforcement of the l e g i s l a t i o n and has been successful i n increasing revenue, and at le a s t i n preventing the s h i f t i n g of taxable p r o f i t s abroad. Like other countries, Canada has followed the U.S. Among i t s several weapons for t a c k l i n g international tax avoidance or 13 evasion by MNCs, Section 69 of the Income Tax Act aims d i r e c t l y at the tr a n s f e r p r i c i n g . Revenue Canada has been making e f f o r t s to a c t i v e l y enforce Section 69 by introducing new audit techniques, 1 4 t r a i n i n g i t s f i e l d auditors and developing cooperation with foreign tax aut h o r i t i e s , e s p e c i a l l y with the IRS. At present, although there i s s t i l l plenty of room for inte r n a t i o n a l tax planning using transfer p r i c i n g by MNCs, i t can be said that tax aut h o r i t i e s have developed f a i r l y e f f e c t i v e counter-measures to cope with such international tax avoidance or evasion. 7 3 . THE PROBLEMS WHICH MNCS ARE FACING I t has to be recognized that every MNC w i l l not always t r y to avoid or evade tax by manipulating tr a n s f e r p r i c e s . Even though the p o s s i b i l i t y of minimizing the o v e r a l l MNC tax burden i s tempting, MNCs might at le a s t t r y to conform to relevant domestic laws i n t h e i r tax planning. Owing to transfer p r i c i n g taxation l e g i s l a t i o n and aggressive enforcement by tax aut h o r i t i e s , the p o s s i b i l i t y of harsh assessments by tax auth o r i t i e s and double taxation 15 therefrom has increased even i n the case of "honest" taxpayers. The s p e c i f i c methods used to calcu l a t e an arm's length price provided by tax laws are too general to be h e l p f u l . In fact, i t might even be impossible for tax auth o r i t i e s to make a general guideline applicable i n every case. In the end, the c a l c u l a t i o n of arm's length prices has been made based on facts and circumstances t e s t i n each case i n p r a c t i c e . 1 6 As a r e s u l t , i t i s very d i f f i c u l t , sometimes even impossible fo r MNCs themselves to f i n d an arm's length p r i c e which w i l l be 17 acceptable to tax au t h o r i t i e s . Furthermore, where one tax authority made a transfer p r i c i n g adjustment on an intra-group transaction of the MNC, unless other relevant tax authorities have made a corresponding adjustment, the MNC has to suffer 18 unrelieved double taxation. In response to the OECD Report "Transfer P r i c i n g and Multinational Enterprises" ("OECD Report"), MNCs complained of 8 the d e f i c i e n c i e s of the present system and the seriousness of double taxation and urged the OECD to make further e f f o r t s to r e l i e v e MNCs from double taxation. Although t h e i r opinions and suggestions are not e n t i r e l y acceptable, i t i s necessary to observe i n t e r e s t s of MNCs as well as the int e r e s t s of tax auth o r i t i e s i n considering a reasonable t r a n s f e r p r i c i n g system and i t s enforcement. 9 CHAPTER I - FOOTNOTES 1 S. R. F. Plasschaert, Transfer P r i c i n g and Multinational  Corporations: an overview of concepts, mechanisms and  regulations, Saxon House (1979), at 3 2 Ibid. 3 3 Transfer P r i c i n g and Multinational Enterprises, Report of the OECD Committee on F i s c a l A f f a i r s (1979), at para. 2 4 J . S. Peterson, International Transfer P r i c i n g : A Canadian Perspective, Report of the Proceedings of the T h i r t y - F i r s t  Tax Conference. Canadian Tax Foundation (1979), at 452 5 Ibid. 452 6 Supra. note 1, at 6 7 Supra. note 1, at 6-7 8 Supra, note 4, at 452-453 9 Supra, note If at 23-24 10 Supra. note i f at 7-8 11 Supra. note If at 73-74 12 Supra. note If at 75-76 13 Revenue Canada can use, f o r example, as a statutory a n t i -avoidance provision, the "FAPI" (foreign accrual property income) r u l e (subparagraph 95(2)(b) of the Income Tax Act), and as j u d i c i a l anti-avoidance doctrines, a "place of central management and cont r o l " t e s t of corporate residence and a "sham" doctrine. 14 Revenue Canada has introduced the "indusrty-wide" audits, the "large f i l e " program (team audits) and the "simultaneous" audits. 15 Supra, note 3, at para. 4 16 Supra, note 3, at para. 5 17 Transfer P r i c i n g , Corresponding Adjustments and the Mutual Agreement Procedure, Transfer P r i c i n g and Multinational  Enterprises: Three Taxation Issues, Report of the OECD 10 Committee on F i s c a l A f f a i r s (1984), at para. Ibid, para. 25 11 CHAPTER I I THE CANADIAN TRANSFER PRICING TAXATION SYSTEM SUBCHAPTER I OUTLINE OF THE CANADIAN SYSTEM 1. LEGISLATION Framework of Section 69 As stated before, the Canadian version of the transfer p r i c i n g taxation system i s provided i n Section 69 of the Income Tax Act ("ITA"). Section 69 (1) Except as expressly otherwise provided i n t h i s Act, (a) where a taxpayer has acquired anything from a person with whom he was not dealing at arm's length at an amount i n excess of the f a i r market value thereof at the time he so acquired i t , he s h a l l be deemed to have acquired i t at that f a i r market value; (b) where a taxpayer has disposed of anything (i) to a person with whom he was not dealing at arm's length f or no proceeds or fo r proceeds le s s than the f a i r market value thereof at the time he so disposed of i t , or ( i i ) to any person by way of g i f t i n t e r vivos, he s h a l l be deemed to have received proceeds of di s p o s i t i o n therefor equal to that f a i r market value; and (c) where a taxpayer has acquired property by way of g i f t , bequest or inheritance, he s h a l l be deemed to have acquired the property at i t s f a i r market value at the time he so acquired i t . Subsection (1) applies to non-arm's length acquisitions and dis p o s i t i o n s of "anything". Paragraph (a) means that the cost of ac q u i s i t i o n may not for tax purposes exceed f a i r market value and paragraph (b) means that the proceeds of d i s p o s i t i o n may not for 12 tax purposes be les s than f a i r market value. (2) Where a taxpayer has paid or agreed to pay to a non-resident person with whom he was not dealing at arm's length as price, r e n t a l , royalty or other payment f o r or f o r the use or reproduction of any property, or as consideration for the carriage of goods or passengers or fo r other services, an amount greater than the amount (in t h i s subsection referred to as "the reasonable amount") that would have been reasonable i n the circumstances i f the non-resident person and the taxpayer had been dealing at arm's length, the reasonable amount s h a l l , f or the purpose of . computing the taxpayer's income under t h i s Part, be deemed to have been the amount that was paid or i s payable therefor. (3) Where a non-resident person has neither paid, nor agreed to pay to a taxpayer with whom he was not dealing at arm's length as price, r e n t a l , royalty or other payment for or for the use or reproduction of any property, or as consideration f o r the carriage of goods or passengers or fo r other services, the amount that would have been reasonable i n the circumstances i f the non-resident person and the taxpayer had been dealing at arm's length, that amount s h a l l , f or the purpose of computing the taxpayer's income under t h i s Part, be deemed to have been received or receivable by the taxpayer therefor. Where a transaction takes place between a Canadian taxpayer and a non-resident with whom the Canadian taxpayer was not dealing at arm's length, these subsections w i l l apply. Subsection (2) means that the amount that the Canadian taxpayer has paid or agreed to pay to the related non-resident may not, for tax purposes, exceed a reasonable arm's length p r i c e and subsection (3) means that the amount that the related non-resident has paid or agreed to pay to the Canadian taxpayer may not, f o r tax purposes, be les s than a reasonable arm's length p r i c e . 2 13 " F a i r market value" vs. "reasonable arm's length p r i c e " According to Revenue Canada, subsections (2) and (3) 3 . . . override subsection (1), although some tax p r a c t i t i o n e r s point . . 4 out that there i s no authority for such overriding. I t must be be c l a r i f i e d whether a " f a i r market value" i n subsection (1) and a "reasonable arm's length p r i c e " i n subsections (2) and (3) are the same or not. The reason why l e g i s l a t o r s have not used the f a i r market value terminology but the d i f f e r e n t terminology, "the amount that would have been reasonable i n the circumstances i f the non-resident person and the taxpayer had been dealing at arm's length" i s thought by Revenue Canada that a reasonable arm's length p r i c e may mean a f a i r market value or another amount depending on the circumstances i n a p a r t i c u l a r case. That i s to say, there may be si t u a t i o n s where the p r i c e which i s more than or l e s s than the f a i r market value can be estblished as the "reasonable arm's length p r i c e " . For example, an intra-group sale of a MNC may take place at lower than the f a i r market value i n order to help a related e n t i t y i n f i n a n c i a l d i f f i c u l t i e s , to increase i t s share i n e x i s t i n g markets, to introduce new products into markets, or to fend o f f increasing competition. I t also can be sa i d that whereas the f a i r market value cannot be p r e c i s e l y determined for many products, i t might be p r a c t i c a l to adopt the arm's length p r i c e approach. 6 However, i n J . Hofert Limited v. Minister of National 7 Revenue. the Tax Appeal Board stated: I discern l i t t l e i f any, p r a c t i c a l difference between " f a i r p r i c e " [ i . e . , reasonable arm's length price] and 14 " f a i r market value" and consider that the observation of Maclean, J . [ i . e . , " f a i r p r i c e " was commercial and not a l e g a l term and involved a question of f a c t into which many considerations might enter] have equal a p p l i c a b i l i t y to the question raised i n t h i s instant matter. 8 In addition, Revenue Canada has stated that i t uses the same theories and p r i n c i p l e s of transfer p r i c i n g to determine the f a i r 9 market value under subsection (1) as subsection (2) and (3). In the end, there may be l i t t l e difference between the two concepts. ( Interestingly, i n practice, Revenue Canada seems to be encouraging taxpayers to take a "clean p r i c e " approach to t r a n s f e r p r i c i n g , that i s , to e s t a b l i s h intercompany pr i c e s that represent only f a i r market value of the product or service i n v o l v e d . ) 1 0 Since i n the case of international t r a n s f e r p r i c i n g , only subsection (2) and (3) apply, i n t h i s paper, a "reasonable arm's length p r i c e " i s the p r i n c i p a l focus. What i s a reasonable arm's length price? The Canadian Income Tax Act only states the above-mentioned general p r i n c i p l e s . There have not been any guidelines such as the U.S. IRC Regulation which states s p e c i f i c methods for c a l c u l a t i n g the arm's length p r i c e . I t would appear that the Canadian taxpayer can use any method of c a l c u l a t i o n i f i t r e s u l t s i n a "reasonable amount". However, Revenue Canada has been making t r a n s f e r p r i c i n g adjustments based on i t s i n t e r n a l assessing guideline. In the past t h i s guideline was not a v a i l a b l e and c l e a r for taxpayers so that they have had 1 5 d i f f i c u l t i e s i n f i x i n g t ransfer prices with c e r t a i n t y and taxpayers and tax p r a c t i t i o n e r s have strongly requested the p u b l i c a t i o n of c l e a r g u i d e l i n e s . 1 1 Eventually, Revenue Canada issued Information C i r c u l a r No. 87-2 ("IC 87-2") on international transfer p r i c i n g and other i n t e r n a t i o n a l transactions. This long-awaited information c i r c u l a r only provides procedures to be followed by Revenue Canada and has no l e g a l impact. However, the s p e c i f i c p r i c i n g methods provided i n i t b a s i c a l l y followed the OECD Report and i t s contents seem f a i r l y reasonable. Considering there has been l i t t l e jurisprudence which d i r e c t l y deals with how to calculate the "reasonable arm's length p r i c e " , i t might be appropriate to discuss the actual a p p l i c a t i o n of the arm's length p r i n c i p l e i n Canada based on t h i s information c i r c u l a r . 2. ARM'S LENGTH PRINCIPLE Arm's length p r i n c i p l e Paragraph 9 of IC 87-2 states that the "arm's length p r i n c i p l e " , i n the context of transactions between part i e s that are not i n fact dealing at arm's length, means that each such transaction should be c a r r i e d out under terms and at a p r i c e that one could reasonably expect i n s i m i l a r circumstances ... had the p a r t i e s been dealing at arm's length. 16 This p r i n c i p l e and the basic methods for f i n d i n g the arm's length p r i c e are the same as those of the OECD Report and the U.S. system. An i d e a l p r i c i n g method for c a l c u l a t i n g the arm's length p r i c e i s arri v e d at by r e f e r r i n g to prices i n comparable transactions between independent corporations or between a member 12 of a MNC and an unrelated party. I f t h i s "comparable uncontrolled p r i c e " method i s not availa b l e or not reasonable to apply, as secondary methods, the "resale p r i c e " method, which s t a r t s with the f i n a l s e l l i n g p r i c e and subtracts an appropriate p r o f i t mark-up, or the "cost plus" method, which s t a r t s with the cost of providing the goods or services etc. and adds an 13 appropriate p r o f i t mark-up could be used. Where these secondary methods are not available or not reasonable to apply, other methods would have to be employed. Necessary consideration to be given i n applying these p r i c i n g methods w i l l d i f f e r i n each type of transaction, such as the transfer of tangible or intangible properties, the provision of services and the use of intangible properties. Before looking into more pr e c i s e l y , there are several issues to be mentioned. Functional Analysis I t i s of v i t a l importance to understand the o v e r a l l operation of a MNC rather than to look into each transaction. The OECD Report states: 17 When examining the transfer prices adopted within a MNE, i t i s always useful to begin by analysing the function of the various e n t i t i e s which comprise the MNE. Some f a m i l i a r i t y with the structure and organization of the group and some knowledge of which e n t i t i e s undertake the r i s k s and r e s p o n s i b i l i t i e s f o r the various a c t i v i t i e s are es s e n t i a l f o r tax auth o r i t i e s to help them i n assessing when a p r o f i t i s l i k e l y to a r i s e and roughly what sort of i t i s i k e l y to be. 14 Revenue Canada seems to f u l l y understand the importance and usefulness of a functional analysis as a necessary step to be taken by i t s f i e l d auditors. A functional analysis w i l l not only be useful f o r finding a reasonable arm's length p r i c e but also for f a c i l i t a t i n g e f f e c t i v e and productive audits. E s p e c i a l l y , a functional analysis i s indispensable for finding an appropriate mark-up or a reasonable a l l o c a t i o n of p r o f i t s among members of a 15 MNC. Package Deal I t i s common to f i n d "package deals" i n intra-group transactions of MNCs that i n which a single charge i s made for a va r i e t y of benefits. For example, a parent company might s e l l products to i t s subsidiary with various technical and administrative services or other benefits i n return for an undifferentiated payment. Since tax treatments for the in d i v i d u a l types of benefits d i f f e r from country to country, i t i s very d i f f i c u l t to deal with a package deal as one transaction i n c a l c u l a t i n g an arm's length p r i c e . 1 6 Therefore, Revenue Canada, following the OECD Report, requires each transaction to be i n d e n t i f i e d as a separate transfer and as a r e s u l t be subject 18 to a separate evaluation and intercompany charge. Paragraph 10 of IC 87-2 states: A separate i d e n t i f i c a t i o n and valuation of the various products and services w i l l not only f a c i l i t a t e the audit of international transactions but w i l l also, where an income tax treaty or convention i s i n force, a s s i s t the treaty partners i n t h e i r negotiations to avoid double taxation. This approach comforms to Revenue Canada's "tansaction-by-transaction" approach. On the other hand, MNCs and tax p r a c t i t i o n e r s have been opposing t h i s approach. I t i s very d i f f i c u l t and sometimes impossible to i d e n t i f y several elements i n a package deal as a separate transaction and evaluate and charge them separately. Furthermore, according to t h e i r opinion, a "transaction-by-transaction" approach i t s e l f contains the danger of unreasonable and unnecessary assessments. One p a r t i c u l a r transaction may seem unreasonable when analyzed apart form other transactions, but when the o v e r a l l maximization of the p r o f i t of the e n t i t y i n the long run i s taken into account, the transaction may be reasonable. In addition, there i s no l e g a l authority f o r the "transaction-by-transaction" approach under Section 69 of the 17 Income Tax Act. In response to the above-mentioned c r i t i c i s m , Revenue Canada has admitted the necessity of modifying i t s approach i n some cases. Paragraph 11 of IC 87-2 states: I f the above [transaction-by-transaction] approach i s not p r a c t i c a l or proves u n r e a l i s t i c i n terms of the manner i n which the p a r t i c u l a r industry conducts i t s 19 business, then the taxpayer should be prepared to provide, i n a comprehensive statement of intercompany p r i c i n g p o l i c y , the basis on which tr a n s f e r p r i c e s are established world-wide. And where i t i s impossible to analyze on a transaction-by-transaction basis, Revenue Canada may allow the taxpayer to analyze the p r i c i n g of a p a r t i c u l a r product during the year, or 18 to focus on a p a r t i c u l a r product l i n e , and so on. Set-offs In connection with package deals and the transaction-by-transaction approach, there i s the further problem of how to tre a t s e t - o f f arrangements i n intra-group transactions of MNCs. Although the si z e and extent of a se t - o f f w i l l d i f f e r , such arrangements can be found i n transactions between unrelated 19 p a r t i e s as well as within MNCs. IC 87-2 does not deal with t h i s issue, however, considering i t s transaction-by-transaction approach, Revenue Canada w i l l s c r u t i n i z e the se t - o f f arrangements of MNCs to determine whether 20 the benefits can be accurately quantified i n advance and whether they do i n fac t balance each other over an appropriate time, and the f i n a l judgement w i l l depend on a reasonably acceptable assessment of what would be an arm's length p r i c e f or 21 a l l the relevant transactions. On the other hand, i n the U.S., i f the se t - o f f would change the character of the income, the items would be taken into 22 account separately. I f appropriate, the IRS may make adjustments 23 even i f no ultimate income was r e a l i z d by the group as a whole. 20 Minor adjustments and su b s t i t u t i o n of methods The OECD Report states, i f the pric e s a c t u a l l y paid can be substantiated by acceptable evidence as being arm's length p r i c e s there would be no j u s t i f i c a t i o n for seeking to make merely minor or marginal adjustment to them for tax purposes. S i m i l a r l y a tax authority should hesitate to disturb without good reason a p r i c i n g arrangement reasonably and consistently operated i n comparable dealings with independent p a r t i e s . 24 This consideration i s recognized as reasonable and indispensable by not only MNCs but also tax a u t h o r i t i e s . Revenue Canada does not seem to be concerned with small percentage differences between actual transfer prices and arm's length p r i c e s . Rather i t t r i e s to concentrate on the areas where p r i c i n g d i f f e r e n t i a l or po t e n t i a l i s substantial i n order to keep audits e f f i c i e n t . S p e c i f i c methods t o ca l c u l a t e the arm's length p r i c e Despite tax au t h o r i t i e s ' strenuous e f f o r t s to set out s p e c i f i c p r i c i n g r u l e s , the determination of the reasonable arm's length p r i c e i s a question of fac t and should be based on each 25 taxpayer's own p a r t i c u l a r circumstances and merits. In addition, as mentioned before, under the Canadian Income Tax Act, there i s no l e g a l authority to require taxpayers to use s p e c i f i c methods provided i n IC 87-2 and there i s l i t t l e d i r e c t jurisprudence as to the p r i c i n g methods of IC 87-2. However, considering that once the taxpayer's transfer 21 pric e s are not accepted by Revenue Canada, the taxpayer would, to avoid double taxation, have to take the issue to the Courts or use the mutual agreement procedure. Most competent authorities are adopting p r i c i n g methods s i m i l a r to those of IC 87-2, and i t can be said that even i f the methods and considerations endorsed by Revenue Canada are not t o t a l l y acceptable to taxpayers, i t i s i n the taxpayer's best i n t e r e s t , and the most p r a c t i c a l solution to follow those p r i c i n g methods. In the following subchapters, I w i l l discuss the s p e c i f i c methods f o r c a l c u l a t i n g the arm's length p r i c e i n r e l a t i o n to various types of transactions: the tra n s f e r of goods, the provision of intra-group services and the tra n s f e r of technology. These discussions w i l l be based on IC 87-2, and where IC 87-2 i s s i l e n t , I w i l l r e f e r to the OECD Report and the U.S. IRC Regulation. 22 SUBCHAPTER I - FOOTNOTES 1 Revenue Canada, International Transfer P r i c i n g and other International Transactions, Information C i r c u l a r 87-2(1987), at para. 5 2 Ibid, para. 6 3 Ibid, para. 6 4 N. Boidman, Canada-U.S. Intercompany (and other) Taxation Issues, Report of the Proceedings of the T h i r t y - F i f t h Tax  Conference. Canadian Tax Foundation (1983), at 322 5 Supra. note 1, at para. 7 6 Supra. note 4, at 322 7 (1962) D.T.C. 50 8 Ibid. 52 9 Supra. note 1, at para. 5 10 J . R. Robertson, A Revenue Canada Perspective on Inter-national Taxation: Transfer P r i c i n g and Related Issues, Report of the Proceedings of the Thirty-Fourth Tax  Conference. Canadian Tax Foundation (1882), at 776 11 See generally, G. T. Tamaki and R. W. Pound, Intercompany P r i c i n g : In search of guidelines, 22 Canadian Tax Journal (1974), 460-471 12 Transfer P r i c i n g and Multinational Enterprises. Report of the OECD Committee on F i s c a l A f f a i r s (1979), at para. 11 13 Ibid, para. 12 14 Ibid, para. 17 15 Supra. note 1, at para. 15 16 Supra. note 12, at para. 19 17 Supra. note 4, at 323 18 Supra. note 10, at 777 19 Supra, note 12, at para. 20 23 20 Supra. note 12, at para. 21 21 Supra. note 12, at para. 22 22 The U.S. IRC Regulation 1.482-l(d)(3) 23 The U.S. IRC Regulation 1.482-l(d)(4) 24 Supra. note 12, at para. 15 25 Supra. note 1, at para. 12 24 SUBCHAPTER I I TRANSFER OF GOODS P r i n c i p l e The arm's length p r i n c i p l e i n intra-group t r a n s f e r of goods i s that p r i c e s paid f o r goods transferred between members of MNCs should be, for tax purposes, those which have been paid between unrelated p a r t i e s for the same or s i m i l a r goods under the same or si m i l a r circumstances. 1 (This p r i n c i p l e w i l l also apply to the outright t r a n s f e r of intangible properties such as patents, 2 mutatis mutandis.) 1. COMPARABLE UNCONTROLLED PRICE METHOD Comparable uncontrolled p r i c e As the OECD Report and the U.S. IRC Regulation do, IC 87-2 provides that the primary method to be applied i s to base the reasonable arm's length p r i c e on a "comparable uncontrolled p r i c e " , i . e . the p r i c e i n comparable transactions between a buyer 3 and a s e l l e r who are not related each other. "Uncontrolled" transactions can be divided into two types: one i s a transaction between a member of a MNC i n question and an unrelated party and, the other i s a transaction between parties 4 which are not related to each other or to the MNC. I f a member of a MNC which sold goods to the other members 25 also sold the same or s i m i l a r goods to unrelated p a r t i e s under the same or s i m i l a r circumstances, the s e l l i n g p r i c e to the unrelated p a r t i e s would be the arm's length p r i c e . In such a case, t h i s comparable uncontrolled p r i c e method i s the easiest and most persuasive method and would r e s u l t i n the most accurate estimate of the arm's length p r i c e , however, i n pra c t i c e i t i s almost impossible to obtain such evidence. Even i f an ideal s i t u a t i o n e x i s t s per se. the comparable uncontrolled transaction has to be comparable with the intra-group transaction i n question i n every respect such as volumes of sale or a u x i l i a r y services. Comparabilitv To apply the comparable uncontrolled p r i c e method, the comparability should be observed c a r e f u l l y i n various aspects. F i r s t , the goods should be the same as or s i m i l a r to those i n the intra-group transaction i n question. Where the goods are p h y s i c a l l y i d e n t i c a l , unless those goods are standardized goods such as natural products or mass manufactured goods, i t does not always mean that they are comparable. As the OECD Report indicates, differences such as exclusive patented feature, trademark, tradename, p e c u l i a r i t y of the package or container, s i n g u l a r i t y i n qualit y , design, color, or s t y l e w i l l a f f e c t p r i c e s . Accordingly i t might happen that p h y s i c a l l y and chemically i d e n t i c a l products are exchanged at d i f f e r e n t prices 5 . . because of such differences. Where the differences e x i s t , i f such differences are capable of q u a n t i f i c a t i o n on some reasonable basis, i t i s s t i l l possible to apply the comparable uncontrolled p r i c e method. Second, geographic markets should be comparable. Where the uncontrolled transaction took place i n a geographically d i f f e r e n t market, the market has to be economically comparable. The differences i n economic and s o c i a l structure, or commercial habits or country's p o l i c i e s make the market p r i c e of the same product vary from one country to another, even within one country as w e l l . Fortunately, the Canadian and U.S. market are economically comparable, however, i n most cases, as the OECD Report states, geographically d i f f e r e n t markets can be s a t i s f a c t o r i l y compared only i f the economic conditions are the 7 same or differences can be e a s i l y eliminated. Third, market l e v e l s should be comparable. I t i s necessary to compare goods at the same point i n the chain from producers to consumers. For example, i f the intra-group transaction was made at the l e v e l of wholesale, the uncontrolled transaction should also be made at the l e v e l of wholesale. Where only data at a d i f f e r e n t l e v e l i s available, i n order to apply the comparable uncontrolled p r i c e method i t has to be possible to quantify such Q differences e a s i l y . 9 In the recent Indalex l i m i t e d v. Her MaTesty The Queen, the Court used the comparable uncontrolled p r i c e method to determine the reasonableness of p r i c i n g between the taxpayer and i t s r e l a t e d company i n Bermuda from which the taxpayer purchased the aluminum b i l l e t . Since v a l i d comparable sales between unrelated p a r t i e s were not available, the Court compared a sale by Alcan (the o r i g i n a l supplier of aluminum b i l l e t to the Bermuda company) 27 to the Bermuda company as the closest arm's length comparable with the sale by the Bermuda company to the taxpayer. 1 0 I t was found that the additional discounts were obtained by the Bermuda company over what the taxpayer could have negotiated on i t s own with Alcan. Then the Court made the adjustment to equate these two transactions by reducing the amount for such extra benefits that the taxpayer received by purchasing from i t s Bermuda company from the comparable p r i c e . 1 1 In addition, the volume of sales, time period during which the transaction took place and other conditions of transactions should be comparable. I f differences e x i s t , such differences should also be e a s i l y adjustable. Furthermore, as stated i n a "package deal", i n intra-group sales by MNCs, provision of a u x i l i a r y services to the buyer or tran s f e r of intangible properties are often included. I t i s necessary to take into account those p o s s i b i l i t i e s . P i r a t e p r i c e In connection with the comparability of goods concerned, the treatment of a "pirate p r i c e " presents a problem. There are differences of opinion between the OECD Report and Revenue Canada. On the one hand, the OECD Report states: Although the prices at which they are sold may give an in d i c a t i o n of the mere cost of production of the patented goods they could hardly be relevant f o r any other purpose as they do not take into account research and development, technical assistance and other connected services. 12 28 Revenue Canada believes, on the other hand, that "to determine the "mere" cost of production i s extremely relevant". Based on experience from studies of Canadian pharmaceutical industry, Revenue Canada f e e l s that "the reference to a "pirate p r i c e " may be quite reasonable i n the circumstances for 13 evaluation of non-arm's length imports". Considering d i f f i c u l t i e s i n obtaining the foreign-based information, a p i r a t e p r i c e might help the tax o f f i c i a l as an in d i c a t i o n of the production cost i n pra c t i c e . Isolated transaction In connection with the comparability of the volume of sales, i t should be noted that some MNCs might make an i s o l a t e d (often, small-scaled) transaction with unrelated p a r t i e s at an u n r e a l i s t i c p r i c e on purpose to j u s t i f y t h e i r t r a n s f e r p r i c e s . At the same time, tax aut h o r i t i e s also should not use such an i s o l a t e d transaction, whether or not the MNC made i t on purpose, as the comparable uncontrolled transaction. In the Hofert case, Revenue Canada made upward adjustments on the s e l l i n g p r i c e of Christmas trees by the taxpayer to the U.S. company with which the taxpayer was not dealing at arm's length, based on the s e l l i n g p r i c e i n the Canadian market. The Court held that since the volume of sales i n the domestic market was only one-ninth of the U.S. sales and there were various differences i n terms and conditions between those two types of sales, Revenue Canada's assessment was an " u n r e a l i s t i c approach" and allowed the taxpayer's appeal. Problems of the comparable uncontrolled p r i c e method Since s t r i c t comparability i s required i n pra c t i c e i t i s very d i f f i c u l t , sometimes impossible to apply the comparable uncontrolled p r i c e method. There i s no s t a t i s t i c a l data av a i l a b l e i n Canada, but according to surveys by the U.S. General Accounting O f f i c e , only 3 percent of the t o t a l t r a n s f e r p r i c i n g adjustment cases by the IRS were based on the comparable 15 uncontrolled p r i c e method. Such a percentage indicates the d i f f i c u l t i e s i n actual applicat i o n of t h i s method. I t often happens that i n intra-group transactions of MNCs the goods are so sp e c i a l i z e d or unique that the MNC would not s e l l them to unrelated p a r t i e s , or that i n highly integrated MNCs goods are processed e n t i r e l y within a group u n t i l ultimate end users. In such cases where semi-finished products or components are i n question, the app l i c a t i o n of the comparable uncontrolled p r i c e method i s im p o s s i b l e . 1 6 2. RESALE PRICE METHOD Secondary methods Where the "comparable uncontrolled p r i c e " i s not available, IC 87-2 recommends the "resale p r i c e " method and "cost plus" 17 method as secondary methods. The resale p r i c e method s t a r t s with the taxpayer's s e l l i n g 30 p r i c e of the goods, which have been purchased from a related s e l l e r , to an arm's length customer and reduces the s e l l i n g p rice by an appropriate mark-up which represents the amount out of which the r e s e l l e r would seek to cover h i s costs and make a p r o f i t . 1 8 Recommended use This method i s thought to be most useful where i t i s applied 19 to marketing operations, more s p e c i f i c a l l y , where the taxpayer does not add value to the goods or does not do any further processing, and the taxpayer are carrying out marketing or s e l l i n g operation. I f the taxpayer does further processing to goods or incorporate into more complicated products so that i d e n t i t y of the goods i s l o s t or transformed, i t would become 20 very d i f f i c u l t to calc u l a t e an appropriate mark-up. An appropriate mark-up An appropriate mark-up can be calculated by reference to gross p r o f i t mark-up (usually expressed as percentage of sales) earned by the taxpayer on the transaction i n which the taxpayer purchased the goods, which i s s i m i l a r to the goods involved i n the non-arm's length transaction, from unrelated p a r t i e s and resold to unrelated p a r t i e s . In a case where such a p r o f i t mark-up i s not available, the p r o f i t mark-up earned by t o t a l l y uncontrolled p a r t i e s may serve as a guide with considerable c a u t i o n . 2 1 Here again, the comparability presents the problem. As the 31 OECD Report states, whereas the comparable uncontrolled p r i c e method c a l l s for the use of comparable p r i c e , the resale p r i c e method c a l l s i n e f f e c t for the use of comparable mark-ups. 22 I t can be said that whichever method i s adopted, we are running i n the same c i r c l e . For mark-ups to be comparable, i t i s important that the functions performed and the r i s k s taken by the r e s e l l e r s i n arm's length transactions should be the same as or s i m i l a r to those i n 23 non-arm's length transactions. For example, as the OECD Report indicates, i f the r e s e l l e r e f f e c t i v e l y performs minimal services as a forwarding agent, i . e . he has to make l i t t l e or no e f f o r t s , h i s p r o f i t mark-up should be small. On the contrary i f the r e s e l l e r takes on the f u l l r i s k of ownership together with the f u l l r e s p o n s i b i l i t y for and the r i s k s involved i n advertizing, marketing, d i s t r i b u t i n g and guaranteeing the goods, financing stocks and other connecting services such as packaging or 24 transport, h i s mark-up should be s u b s t a n t i a l l y high. Therefore, Revenue Canada strongly recommends that a thorough functional analysis of a c t i v i t i e s of members of MNCs, which w i l l i d e n t i f y and evaluate with respect to a given product or product l i n e , the r o l e and contribution of each member, be ca r r i e d o u t . 2 5 Where there are differences i n functions performed by the r e s e l l e r , unless such differences are quantifiable and adjustable, the mark-up i n the non-arm's length transaction cannot be a comparable mark-up. As to the s i m i l a r i t y of goods, since primary emphasis i s placed on the comparability i n functions and a lack of close s i n g u l a r i t y of goods i s not necessarily i n d i c a t i v e of d i s s i m i l a r mark-up percentages, such close physical s i m i l a r i t y of goods as under the comparable uncontrolled p r i c e method i s not required 27 under t h i s method. Whether or not the r e s e l l e r has the exclusive r i g h t to r e s e l l the goods, the e f f e c t of any intangible property such as trademarks used by the r e s e l l e r and the geographical market i n which the transactions took place should be taken into account. In addition, the resale should take place within a short time before or a f t e r the time of the controlled sale. Summing up As stated before, where the goods i n question are semi-f i n i s h e d products or one of many parts of a larger unit, or where s i g n i f i c a n t processing has been done to the goods, i t i s impossible to apply the resale p r i c e method. Although Revenue Canada and the OECD Report do not have a p a r t i c u l a r preference f o r the resale p r i c e method or the cost plus method, according to the U.S. IRC Regulation, the resale p r i c e method involves fewer and easier computations and evaluations. Accordingly i t i s l i k e l y to r e s u l t i n a more accurate representation of an arm's length p r i c e than the cost plus method. 2 8 3. COST PLUS METHOD Recommended use In the cost plus method, the c a l c u l a t i o n s t a r t s with the transferor's cost of goods and then i s added an appropriate 2 9 mark-up. The a p p l i c a t i o n of t h i s method would be most useful i n the following s i t u a t i o n s where: (a) Semi-finished products which require s i g n i f i c a n t processing 30 are sold between related p a r t i e s ; (b) D i f f e r e n t e n t i t i e s of a MNC have concluded j o i n t f a c i l i t y 31 agreements or long term buy-and-supply arrangements; (c) The subsidiary e s s e n t i a l l y performs a r o l e of subcontractor 32 and goods sold are nominal parts of a larger un i t ; (d) The goods are s p e c i a l i z e d product t a i l o r e d to s u i t the 33 i n d i v i d u a l customer; (e) There are a few major cost components involved. However, t h i s method contains two major problems; assessing cost and an appropriate mark-up. Cost While cost accounting concepts are not universal and vary 34 from country to country and from business to business, IC 87-2 requires the cost be computed i n accordance with generally accepted accounting p r i n c i p l e s or normal commercial accounting practices i n the industry i n Canada. 35 34 I f the cost accounting method of the taxpayer are suitable and appropriate and used consistently by the taxpayer, Revenue 36 Canada would accept i t . Where the cost of the p a r t i c u l a r goods include a number of cost components or costs which vary over a period such as costs of input of materials or labor, considering that i n MNCs various types of products are being manufactured i n the same f a c i l i t y and at the same time and the volume of a c t i v i t i e s fluctuates, i n practice, as the OECD Report suggests, i t may often be necessary to accept some averaging of the cost incurred over a period of time, over a group of products, over a p a r t i c u l a r l i n e of production. 37 In addition, the OECD Report also indicates, t h i s method has a tendency "to over-emphasize h i s t o r i c a l costs, ignore demands 38 and f a i l s to r e f l e c t competitive conditions adequately." Where such costs as c a p i t a l expenditure or advertising campaigns are to be allocated between members of a MNC, the a l l o c a t i o n of such costs would require complicated work and 39 thorough functional analysis. An appropriate mark-up An appropriate mark-up can be calculated by reference to the the gross p r o f i t percentage (usually expressed as a percentage of cost) earned by the taxpayer on the transaction i n which the taxpayer sol d the goods, which are s i m i l a r to the goods involved i n the non-arm's length transaction, to unrelated p a r t i e s . I f such a comparable transaction i s not available, an appropriate 35 mark-up can be calculated by reference to the transaction i n which the unrelated person sold the goods, which are s i m i l a r to the goods involved i n the non-arm's length transaction, to 40 unrelated p a r t i e s . The comparability also becomes a key consideration under t h i s method. As under the resale p r i c e method, actual economic functions performed by the s e l l e r (taxpayer) and other e n t i t i e s of the MNC 41 should be analyzed. The s i m i l a r i t y of the type of goods, the e f f e c t of any intangible property used by the r e s e l l e r and geographical markets should also be taken into account. Such close physical s i m i l a r i t y of the goods as under the comparable uncontrolled p r i c e method i s not required under t h i s method for 42 the same reason mentioned i n the resale p r i c e method. Cost accounting methods also should be considered. Since an appropriate mark-up w i l l vary with the costing method. IC 87-2 states: I f the cost includes only d i r e c t production costs, an appropriate mark-up would be an amount that i s s u f f i c i e n t to cover normal i n d i r e c t overhead and general and administrative expenses plus a reasonable p r o f i t contribution, whereas i f a f u l l absorption costing method i s used, a lower mark-up would be indicated. 43 Therefore, where the costing data of the comparable transaction i s not available, the ap p l i c a t i o n of t h i s method becomes d i f f i c u l t . Where there are differences i n the above-mentioned items between the comparable transaction from which an appropriate 36 mark-up would be derived and the non-arm's length transaction, the mark-up must be adjusted to r e f l e c t such differences. Such differences should be those which have a d e f i n i t e and reasonably 44 ascertainable e f f e c t on p r i c e . Summing up Considering that i n practice i t i s often impossible to obtain.the costing data of comparable transactions (even the d e t a i l s of costing data of the taxpayer with respect to the transaction i n question are often not a v a i l a b l e ) , t h i s cost plus method would be useful i n s p e c i f i c , l i m i t e d s i t u a t i o n s . However, i t may also be useful as a means to v e r i f y p r o v i s i o n a l l y 45 acceptable p r i c e s a f t e r other methods have been applied. 4. OTHER METHODS AND GENERAL CONSIDERATIONS  "Forth" method Where none of the above-mentioned basic three methods are ava i l a b l e or reasonable to apply, other methods should be employed to calc u l a t e the arm's length p r i c e . Such " f o r t h " methods may also be necessary to support or to cross-check the 46 pr i c e derived by the basic three methods. IC 87-2 provides only one example of the other methods as a v e r i f y i n g measure of the proposed p r i c e . This method uses the following check-points; "cost of d i r e c t materials", " f u l l cost of production", "value as a replacement part" and "value as a f r a c t i o n of the market value of the whole product". Since IC 87-2 does not intend that t h i s example i s exhaustive, i t i s expected that, i n actual assessments, Revenue Canada would and should use other methods such as the OECD Report recommends. Comparable p r o f i t method (industry average method) This method compares the taxpayer's o v e r a l l performance or the gross p r o f i t of a p a r t i c u l a r product l i n e with that of other s i m i l a r corporations i n the same or s i m i l a r circumstances, or that of the industry's average. 4 8 The OECD report states: Levels of p r o f i t i n an industry may for example conform to a pattern and an exception to the pattern might indicate that p r o f i t s were being s h i f t e d by a r t i f i c i a l t r a n s f e r p r i c e s . 49 However, the Report continues that exceptional p r o f i t s or losses do not necessarily mean the r e s u l t of a r t i f i c i a l t ransfer p r i c i n g and the taxpayer could provide a l o g i c a l explanation for 50 the discrepancy. Therefore, comparison should be made with care, and i n pr a t i c e t h i s method would be useful only as pointers 51 for further i n v e s t i g a t i o n . P r o f i t a l l o c a t i o n method ("global w approach method) According to the OECD Report, t h i s method i s to a l l o c a t e some proportion of the combined net income a r i s i n g from a sales transaction to the various associated corporations concerned i n i t on the basis of 38 t h e i r proportionate contribution to the f i n a l p r o f i t . 52 Such basis for contribution could be the r a t i o of respective sale of one e n t i t y to t o t a l sales of a MNC, respective manufacturing cost to t o t a l manufacturing cost, respective labor 5 3 forces to t o t a l labor forces, or combination of several r a t i o s . A world-famous "unitary tax" system i n the State of C a l i f o r n i a i s based on the formula using the r a t i o s of sales, p a y r o l l and assets. This method has been c r i t i c i z e d by the OECD, tax authorities and MNCs for a number of reasons: (a) This method would necessarily be a r b i t r a r y and an a l l o c a t i o n < 54 of p r o f i t s may bear no sound r e l a t i o n s h i p to the economic f a c t s ; (b) To reduce such an a r b i t r a r i n e s s of the r e s u l t s to a n e g l i g i b l e degree would necessitate a complex functional 55 analysis; (c) This method requires f u l l information about t o t a l a c t i v i t i e s of the whole MNC, but such information might not be a v a i l a b l e for the tax a u t h o r i t i e s and i t would impose an i n t o l e r a b l e adminis-t r a t i v e burden on the taxpayers to require them to provide such i n f o r m a t i o n ; 5 6 (d) From the viewpoint of tax a u t h o r i t i e s , t h i s method does not e f f e c t i v e l y h i g h l i g h t double-charging, and does not ensure that 57 the tax authority receive a f a i r share of tax haven p r o f i t s ; (e) Unless the s p e c i f i c global method i s accepted by the relevant countries, i t would r e s u l t i n double taxaion. I t i s i n fact impossible that a l l countries concerned could agree on a formula 39 that could be applied under t h e i r respective tax law and d i f f e r e n t accounting methods. Therefore, the OECD Report d i d not recommend t h i s method and Revenue Canada has also been reluctant to adopt i t . However, i n pra c t i c e , t h i s method might be acceptable as a l a s t resort where other methods cause serious d i f f i c u l t i e s and the relevant tax aut h o r i t i e s are able to adopt a common approach, and necessary information could be available, or useful as a measure to check 59 the assessment using other methods. Net y i e l d expectation (return on investment) method This method i s to compare the y i e l d or return on the c a p i t a l invested i n the taxpayer i n question with the y i e l d or return on the c a p i t a l invested i n corporations, which are carrying on si m i l a r a c t i v i t i e s or requiring the same kind of c a p i t a l investment. 6 0 Another a l t e r n a t i v e i s to compare the return on investment by the taxpayer i n question with the return which the taxpayer could get from investing the c a p i t a l i n other ways. 6 1 This method also presents d i f f i c u l t i e s . To apply the f i r s t approach, the f i n a n c i a l structuring of the comparable corporation should be e s s e n t i a l l y s i m i l a r to that of the taxpayer. I f not, the d i f f i c u l t adjustments should be made to the c a l c u l a t i o n i n 62 order to ensure the comparability. The second approach i s so 63 a r b i t r a r y and imprecise that i t cannot be used i n i s o l a t i o n . However, t h i s method might be useful i n some cases as an 64 i n d i c a t i o n of a reasonable range of possible p r o f i t margins. 40 The order of p r i o r i t y i n ap p l i c a t i o n of methods The U.S. IRC Regulation provides that the basic three methods should be applied i n the order of the comparable uncontrolled p r i c e method, resale p r i c e method and cost plus method. 6 5 According to the regulation, the comparable uncontrolled p r i c e method would r e s u l t i n the most accurate estimate of an arm's length p r i c e , and as stated before, the resale p r i c e method would r e s u l t i n the next most accurate estimate for the reason that the arm's length p r i c e under the resale p r i c e method i s "based more d i r e c t l y upon actual arm's length transactions than under the cost plus method." 6 6 On the other hand, the OECD Report and Revenue Canada, although they t r e a t the comparable uncontrolled p r i c e method as a primary method, whereas the resale p r i c e method and cost plus method as secondary methods, do not provide the s t r i c t order of p r i o r i t y . Considering that the s t r i c t order of p r i o r i t y , i . e . the preference of the comparable uncontrolled p r i c e method by the U.S. Regulation, might have enforced the IRS f i e l d auditor to make subjective approximation of the arm's length p r i c e , the approach of the OECD Report and Revenue Canada would be preferable. In connection with t h i s issue, there seem to be some misunderstandings among the Canadian taxpayers and tax p r a c t i t i o n e r s as to Revenue Canada's p o l i c y , that i s , whether the 41 " f o r t h " method may be accepted by Revenue Canada where one of the 67 basic three methods i s also applicable and reasonable. While the U.S. IRC regulation provides that where one of the basic three methods i s applicable, such method must be u t i l i z e d unless the taxpayer can es t a b l i s h that, considering a l l the facts and circum-stances, some method other than the three methods i s c l e a r l y more applicable. 68 On the other hand, Revenue Canada does not state t h e i r p o l i c y i n IC 87-2. Therefore, taxpayers and tax p r a c t i t i o n e r s are a f r a i d that Revenue Canada might intend to, i n fact, enforce the taxpayer to use the three methods i n any case. However, since the Canadian taxpayer can use any p r i c i n g method, providing that i t r e s u l t s i n a reasonable arm's length p r i c e , under the Income Tax Act, and judging from actual transfer p r i c i n g cases which were successfully s e t t l e d between Revenue Canada and taxpayers, i t seems that regardless of the recommended order of p r i o r i t y of IC 87-2, the f i e l d auditors of Revenue Canada might be allowed to use the method which provides the most appropriate evidence i n the p a r t i c u l a r circumstances. In other words, that Revenue Canada has the same p o l i c y i n t h i s matter as the IRS i n i t s actual enforcement. C o n f i d e n t i a l i t y of the t h i r d party To c a l c u l a t e arm's length p r i c e s , e s p e c i a l l y where one of the three methods i s applied, information on comparable prices or mark-up from the t h i r d p a r t i e s i s indispensable. 42 However, where Revenue Canada obtained information on comparable transactions from the t h i r d p a r t i e s , subsection 241(1) of the Income Tax Act pro h i b i t s Revenue Canada from d i s c l o s i n g such information to the taxpayer i n question; unless the permission to di s c l o s e the information i s granted by the t h i r d p a r t i e s , Revenue Canada has to wait u n t i l l e g a l proceedings have commenced with respect to the assessment issued. In other words, u n t i l the taxpayer has f i l e d a Notice of Claim with the Tax Court of Canada or the Statement of Claim with the Federal Court of Canada.(Subsection 241(3) of the I T A ) 6 9 This r u l e often causes serious problems i n the actual assessment. Where the auditor discusses with the taxpayer on his proposed arm's length p r i c e , he cannot provide any d e t a i l s of the comparables used i n the c a l c u l a t i o n which would enable the taxpayer to deduce the i d e n t i t y of the comparables. Accordingly, i n a p a r t i c u l a r case, the auditor might be forced to negotiate and persuade as to the reasonableness of his assessment without showing i t s basis and i t would make the procedure time-consuming and cause unnecessary arguments or tax l i t i g a t i o n s . Custom duties The difference i n approach between income tax administration and custom administration sometimes made MNCs face a d i f f i c u l t s i t u a t i o n . For example, where the pr i c e for imported goods i n a p a r t i c u l a r intra-group transaction by a MNC i s accepted by the custom administration, i f such transfer p r i c e i s not accepted as an arm's length p r i c e f or income tax purposes by the tax 43 authority, the MNC has to su f f e r the adjustment, v i c e versa. In other words, MNCs have to f i x t h e i r transfer p r i c e s to conform to various c o n f l i c t i n g requirements by d i f f e r e n t administrations 70 within the same country. Therefore i t has been suggested that income tax authorities should accept the value f o r custom duties established for 71 imported goods. However, as the OECD Report suggests, since custom and income tax administration are not always looking at 72 the same sort of transfers, i . e . , valuation of goods are not made i n the same context by the respective administration, such difference i s in e v i t a b l e and i t i s not appropriate to oblige the income tax au t h o r i t i e s to accept the value for custom duties i n a l l cases. Although most of custom l e g i s l a t i o n or administration are applying the arm's length p r i n c i p l e which i s equivalent to that 73 of income tax and accordingly, i n pr a t i c e , the value f o r custom duties might be s i m i l a r to the tran s f e r prices which are acceptable f o r tax aut h o r i t i e s , Revenue Canada c l e a r l y states i n IC 87-2 that the Department i s under no o b i l i g a t i o n to accept the established or reported value for duty when considering the income tax implication of a non-arm's length importation. 74 Safe haven The OECD Report states, i t may be h e l p f u l to consider whether l i m i t s of 44 tolerance could be formulated i n advance by tax aut h o r i t i e s and made known to enterprises by what are sometimes known as safe haven rules, i n d i c a t i n g that p r i c e f a l l i n g within c e r t a i n ranges would be accepted without question. 75 Such safe haven rules might be useful f o r taxpayers as well as tax au t h o r i t i e s i n the various aspects. However, t h i s approach presents several d i f f i c u l t i e s : F i r s t , safe haven rules tend to be a r b i t r a r y and would not f i t i n a l l cases even within the same industry and tend to 76 obsolete as business conditions change. Second, i t would be d i f f i c u l t to minimize such a r b i t r a r i n e s s and obsolescence, and would need considerable and continuous work . . 77 by tax a u t h o r i t i e s . Third, i t would also be d i f f i c u l t to f i x a safe haven range 78 of p r i c e s which i s acceptable to a number of countries. Fourth, safe haven ranges would a f f e c t the prices i n the 79 open market. F i f t h , t h i s approach might provide an avenue f o r tax avoidance. 8 0 Therefore, the OECD Report does not recommend t h i s safe haven ru l e and Revenue Canada does not express any idea i n IC 87-2. On the other hand, i n the area of intra-group loan of MNCs, the U.S. IRC Regulation adopted safe haven rules for arm's length i n t e r e s t rates; that i s , i f the p a r t i c u l a r i n t e r e s t rate charged i n intra-group loan or advance, which meets the conditions prescribed i n the regulation, f a l l s within the range prescribed 45 i n the regulation, the i n t e r e s t rate i n question w i l l be accepted 81 by the IRS. In a s i m i l a r way, the Canadian Income Tax Act provides the r u l e that i n a non-arm's length loan by a Canadian corporation to a non-resident person without i n t e r e s t at a reasonable rate, the lender s h a l l be deemed to have received 82 i n t e r e s t computed at a prescribed rate. (Since such prescribed 83 rates i n the Income Tax Regulation i s not provided as a range of i n t e r e s t but a single rate, i t might not be c a l l e d a "safe haven range".) I t should be noted that Revenue Canada has been considering whether i t might be possible to develop standard international guidelines f o r Canada and using them i n s p e c i f i c circumstances. 8 4 For example, Revenue Canada does not question r o y a l t i e s of 6 per-cent or l e s s on patented phamaceutical products i n audit of that 85 industry. And i t can be expected that through the j o i n t industry study with the IRS, Revenue Canada would increase s p e c i f i c areas i n which safe haven rules could be used. 46 S U B C H A P T E R I I - FOOTNOTES 1 Transfer P r i c i n g and Multinational Enterprises. Report of the OECD Committee on F i s c a l A f f a i r s (1979), at para. 37 2 Revenue Canada, International Transfer P r i c i n g and Other International Transactions, Information C i r c u l a r 87-2 (1987), at para. 13 3 Ibid. para. 13 4 Supra. note 1, at para. 48 5 Supra. note 1, at para. 52 6 Supra, note 2, at para. 14 7 Supra. note 1, at para. 49 8 Supra. note 1, at para. 50 9 (1986) D.T.C » • 6039 10 Ibid. 6048 11 Ibid. 6051 12 Supra. note 1, at para. 52 13 J . R. Robertson, A Revenue Canada Perspective on Inter-national Taxation: Transfer P r i c i n g and Related Issues, Report of the Proceedings of the Thirty-Fourth Tax  Conference. Canadian Tax Foundation (1982) , at 778 14 (1962) D.T.C. 52 15 IRS Could Better Protect U.S. Tax Interest i n Determining the  Income of Multinational Corporations, Report to the Chairman of the House Committee on Ways and Means, the U.S. General Accounting O f f i c e (1981), at 27 16 Supra, note 1, at para. 38 17 Supra. note 2, at para. 16 18 Supra. note 1, at para. 56 19 Supra. note 1, at para. 56 20 Supra , note 1, at para. 57 21 Supra , note 1, at para. 62 22 Supra , note 1, at para. 57 23 Supra r note 1, at para. 59 24 Supra , note 1, at para. 59 25 Supra , note 2, at para. 15 26 The U .S. IRC Regulation 1.482 -2(e)(3)(Vi)(d) 27 Supra r note 1, at para. 61 28 The U .S. IRC Regulation 1.482 - 2 ( e ) ( 3 ) ( i i i ) 29 Supra , note 2, at para. 16 30 Supra , note 1, at para. 65 31 Supra , note 1, at para. 65 32 Supra r note 1, at para. 65 33 Supra note 1, at para. 65 34 Supra note 1, at para. 66 35 Supra note 2, at para. 17 36 Supra. note 1, at para. 66 37 Supra. note 1, at para. 66 38 Supra t note 1, at para. 64 39 Supra. note 1, at para. 68 40 Supra. note 1, at para. 69 41 Supra, note 1, at para. 69 42 The U. S. IRC Regulation 1.482-- 2 ( e ) ( 4 ) ( i i i ) 43 Supra. note 2, at para. 17 44 The U. S. IRC Regulation 1.482 -2(e)(4)(v) 45 Supra. note 1, at para. 63 46 Supra. note 2, at para. 19 48 47 Supra. note 2, at para. 20 48 Supra. note 1, at para. 71 49 Supra, note 1, at para. 71 50 Supra. note 1, at para. 71 51 Supra t note 1, at para. 71 52 Supra. note 1, at para. 72 53 Supra. note 1, at para. 14 54 Supra. note 1, at para. 14 55 Supra. note 1, at para. 14 56 Supra, note 1, at para. 14 57 Supra. note 13 , at 777 58 Supra. note 1, at para. 14 59 Supra. note 1, at para. 14 60 Supra. note 1, at para. 73 61 Supra. note 1, at para. 74 62 Supra. note 1, at para. 73 63 Supra. note 1, at para. 74 64 Supra. note 1, at para. 74 65 The U.S. IRC Regulation 1.482-2(e)(1)(ii) 66 Ibid 67 N. Boidman, Canada-US Intercompany (and other) Taxation Issues, Report of the Proceedings of the T h i r t y - F i f t h Tax  Conference. Canadian Tax Foundation (1983), at 335 68 The U.S. IRC Regulation 1.482-2(e)(1)(iii) 69 Supra. note 2, at para. 48 70 Supra. note 1, at para. 4 71 Supra, note 2, at para. 21 49 72 Supra, note 1, at para. 29 73 Supra. note 1, at para. 29 74 Supra, note 2, at para. 22 75 Supra. note 1, at para. 16 76 Supra. note 1, at para. 16 77 Supra, note 13, at 778 78 Supra. note 1, at para. 16 79 Supra. note 1, at para. 16 80 Supra. note 1, at para. 16 81 The U.S. IRC Regulation 1.482-2(a)(2)(iii) 82 Subsection 17(1) of the Income Tax Act 83 Part XLIII of the Income Tax Regulations 84 Supra. note 13, at 777-778 85 Supra. note 13, at 778 50 SUBCHAPTER I I I PROVISION OF INTRA-GROUP SERVICES - MANAGEMENT OR ADMINISTRATION SERVICES -1. INTRODUCTION In MNCs v a r i o u s types o f i n t r a - g r o u p s e r v i c e s such as a d m i n i s t r a t i v e , t e c h n i c a l and commercial s e r v i c e s a re p r o v i d e d by parent companies o r s p e c i a l i z e d s u b s i d i a r i e s t o o t h e r members of MNCs. The nature and number of these i n t r a - g r o u p s e r v i c e s depends on the k i n d o f b u s i n e s s and on the o r g a n i z a t i o n a l s t r u c t u r e o f each MNC.1 The c o s t s o f p r o v i d i n g i n t r a - g r o u p s e r v i c e s a r e i n i t i a l l y i n c u r r e d by a par e n t company or s p e c i a l i z e d s e r v i c e c e n t e r s and may be re c o v e r e d i n a v a r i e t y o f 2 ways from the o t h e r members o f the MNC. Si n c e a pa r e n t company can de c i d e i n most cases o n e - s i d e d l y how t o charge o r a l l o c a t e t he expenses i n c u r r e d f o r i n t r a - g r o u p s e r v i c e s , t h e r e would be the p o s s i b i l i t y o f s h i f t i n g p r o f i t s or 3 double d i p p i n g . T h e r e f o r e , i n t r a - g r o u p s e r v i c e arrangements o f MNCs i n t e r e s t the t a x a u t h o r i t i e s . On the o t h e r hand, treatments o f i n t r a - g r o u p s e r v i c e arrangements f o r t a x purposes, such as the d e d u c t i b i l i t y o f the expenses, v a r y from country t o country. For example, whereas the ta x a u t h o r i t y o f the country i n which a par e n t company i s 5 1 situated, might require the parent company to charge most of central management or administration expense incurred by i t , to i t s s u b s i d i a r i e s abroad. The tax authority of the country i n which the subsidiary i s situated, might not accept such expenses as deductible. Therefore, there would be the p o s s i b i l i t y of 4 double or multiple taxation of p r o f i t s of a MNC. While some of intra-group services are the same as those which could be provided by independent p a r t i e s , most of intra-group services are s p e c i f i c to MNCs because of special interdependence or c e n t r a l i z a t i o n . Accordingly, more deliberate consideration should be given i n applying the arm's length p r i n c i p l e to provisions of management or administration 5 services. In addition, i t should be noted that intra-group arrangements fo r rendering services share some common features with those f o r making intangible properties a v a i l a b l e . Where technical services are linked with patents or know-how contracts and not renumerated separately, although tax a u t h o r i t i e s usually require taxpayers to evaluate and charge separately, i t may become very d i f f i c u l t to d i s t i n g u i s h . 6 2. JUSTIFICATION OF BENEFITS Real b e n e f i t t e s t IC 87-2 states: 52 An a l l o c a t i o n of central management expenses to a Canadian taxpayer i s acceptable only i f the taxpayer i s i n a p o s i t i o n to derive a r e a l benefit from the related service. 7 In other words, for central management expense to be deductible or chargeable, "who benefits from the a c t i v i t i e s " t e s t has to be met. This r e a l benefit can be conferred according to reasonable expectation at the time the service i s rendered, even i f i t i s p o t e n t i a l or intended benefit. Central management expenses Paragraph 25 of IC 87-2 categorizes central management expenses into three types: (a) expenses that are incurred by the parent company i n i t s " c u s t o d i a l " capacity, i . e . , as a shareholder managing i t s investments i n subsidiaries rather than i n the provision of services to i t s sub s i d i a r i e s (these expenses should be borne by the parent and applied against i t s income from investments); (b) expenses such as the costs of t r a i n i n g workers f o r a new plant that are c l e a r l y incurred for the benefit of a singl e company i n the group and are associated with the provision of s p e c i f i c i d e n t i f i a b l e services to that company; and (c) expenses that are incurred for the benefit of a number of companies or the group as a whole and are for shared services and f a c i l i t i e s , such as a ce n t r a l i z e d world-wide insurance department, that are usually c e n t r a l i z e d for convenience or economy. Whereas the expenses of type (a) are c l e a r l y not chargeable to the su b s i d i a r i e s , the expenses type (b) are c l e a r l y chargeable to the subsidiary and the only problem i s the reasonableness of the amount. The expenses of type (c) can be chargeable or 53 a l l o c a b l e to the subsidiaries to the extent of r e a l benefits derived by the s p e c i f i c s u b s i d i a r y 1 0 and present complicated problems. Shareholder costs The expenses of type (a) are so-called "shareholder costs". As the OECD Report states, expenses incurred by a parent company i n managing and protecting i t s investment are incurred by the parent company as a shareholder and would not be properly chargeable to the other members of the MNC. 11 Other expenses such as costs of the parent's audit of i t s subs i d i a r i e s , expenses incurred by the parent company i n arrang-ing meetings of i t s own shareholders and f o r consolidating the re s u l t s of the members of the group, which may be distinguished as prima f a c i e incurred s o l e l y for the parent's benefit, are also 12 not chargeable to the other members of the MNC. Although, the OECD Report recognized the p o s s i b i l i t y that such costs may be p a r t l y incurred for the benefit of the 13 sub s i d i a r i e s , MNCs have complained that the report interprets 14 shareholder costs too broadly, and suggested that non-deductible or non-chargeable shareholder costs should be l i m i t e d s t r i c t l y to those incurred by a parent company s o l e l y i n i t s capacity as an 15 investor i n the other group a f f i l i a t e . Any costs att r i b u t a b l e to coodinating the various business a c t i v i t i e s of the group should not be included i n such shareholder c o s t s . 1 6 As the OECD report "Transfer P r i c i n g and Multinational 54 Enterprises: Three Taxation Issues" ("OECD 1984 Report") indicates, shareholder costs may be distinguished from costs which are incurred, i n order to render the conglomerate more p r o f i t a b l e than the t o t a l of various i n d i v i d u a l parts of i t would be i f not relat e d . 17 That i s to say, i t should be recognized that the p r o f i t -making capacity of subsidiaries of a MNC i s often enhanced by the 18 managerial and coordinating a c t i v i t i e s of a parent company. Therefore, the approach which deems that the above-mentioned add i t i o n a l a c t i v i t i e s by a parent company are made for the benefit of the other members, might be reasonable. Based on t h i s approach, shareholder costs, which should be borne by a parent company and not deductible by the other members of the MNC, would be l i m i t e d as follows: (a) Costs of a c t i v i t i e s r e l a t i n g to the j u r i d i c a l structure of the parent company i t s e l f , such as meetings of shareholders of the parent, issuing of the shares i n the parent company and costs of the supervisory board; (b) Costs r e l a t i n g to reporting requirements of the parent company including the consolidation of the reports; (c) Cost of r a i s i n g funds for the a c q u i s i t i o n of i t s p a r t i c i p a t i o n s ; (d) Costs of managerial and control (monitoring) a c t i v i t i e s related to the management and protection of the investment as such i n p a r t i c i p a t i o n s . 19 The costs of type (d), as the OECD 1984 Report indicates, should be distinguished from the costs of managerial, control and coodinating a c t i v i t i e s to improve the operation of the 55 20 s u b s i d i a r i e s , but those a c t i v i t i e s may be performed by the same persons and the same departments as the a c t i v i t i e s i n type (d), 21 actual c l a s s i f i c a t i o n would be very d i f f i c u l t . I t should also be noted that management or administration a c t i v i t i e s by the parent company do not always benefit the other members of the MNC.22 On the contrary, the tax a u t h o r i t i e s ' approach i s that, as IC 87-2 states, unless the other member of the MNC derives a r e a l benefit from the service performed by the parent, the costs incurred by the parent company would not be chargeable to the 23 other member. The difference i n approach between MNCs and tax a u t h o r i t i e s , or between tax a u t h o r i t i e s would cause double taxation. The appropriate ways to eliminate these d i f f i c u l t i e s would be, as the OECD 1984 Report recommends, to define s p e c i f i c a l l y the scope of "shareholder costs" on a b i l a t e r a l basis by r e v i s i n g protocol provisions of relevant tax conventions or through follow-up meetings to simultaneous examination or through mutual agreement procedures. 2 4 Service on c a l l In the case of subparagraph 25(b) of IC 87-2, since the expenses were c l e a r l y incurred f o r the benefit of the subsidiary and s p e c i f i c i d e n t i f i a b l e services were provided, the only problem i s the reasonableness of the amount of expenses. However, such services are sometimes provided "on c a l l " , i n 25 return f o r payments i n the form of an annual f l a t rate fee. As 56 the OECD Report indicates, i t may well happen that even i f the services are not used i n a given year they may be used i n t e n s i v e l y i n another year, 2 6 therefore, i t would be appropriate for the tax aut h o r i t i e s to look at the continuous stream of a c t i v i t i e s and the benefits received over a period of more than one year. 2 7 Indirectness or remoteness of a benefit In a l l o c a t i n g the expenses incurred for the a c t i v i t i e s which may benefit to varying degrees the parent, the group as a whole, or one or more other members of the MNC, i t would be very d i f f i c u l t to determine whether a r e a l benefit has accrued to the other members of the group. Where the expenses are incurred for central management, coodinating and control a c t i v i t i e s , which MNCs suggest not be treated as non-chargeable "shareholder costs", since such a c t i v i t i e s benefit p a r t l y the parent and to some extent the other members of the MNC, the benefit which the 2 8 s u b s i d i a r i e s could derive i s i n d i r e c t or remote. As the OECD Report states, "an i n d i r e c t or remote benefit to the s u b s i d i a r i e s would not j u s t i f y a deduction f o r tax 2 9 purposes". Although, as the report suggests, "whether the member would have bought the service had i t been on o f f e r from an 30 independent t h i r d party may also be a relevant factor" to determine the chargeability or d e d u c t i b i l i t y of the central management expenses, i t may be necessary to analyze the r e s p o n s i b i l i t i e s , functions, performance and p r o f i t s of the 31 various members of the MNC. In addition, paragraph 26 of IC 87-2 57 indicates: Where a resident taxpayer i s st a f f e d by a management team normally associated with a s e l f - s u f f i c i e n t business, the a l l o c a t i o n should be l i m i t e d to expenses that can c l e a r l y be i d e n t i f i e d with the taxpayer and which do not represent a duplication of service already provided by Canadian personnel. On the other hand, MNCs seem to accept the "benefit t e s t " i n the case that s p e c i f i c services are rendered to the s p e c i f i c 32 subsidiary; however, they have argued that costs of central a c t i v i t i e s f or the benefit of the group as a whole should be paid f o r by the group members, whether or not a s p e c i f i c benefit (actual or intended) can be demonstrated, each respective share being determined by an appropriate apportionment formula. 33 3. METHOD OF AT.T/ir&TION AND APPORTIONMENT MNCs1common charging methods According to the OECD 1984 Report, MNCs usually employ the following methods to charge central management costs to i t s members: (a) Charging d i r e c t l y for i n d i v i d u a l i s e d services; (b) A l l o c a t i n g and apportioning costs to each of the associated corporations (usually by reference to an estimate of t h e i r share i n the benefits a r i s i n g from the services) - "cost sharing"; (c) Remunerating the group service center by a contribution from other parts of the group related to some broad aspect of the business of the enterprises concerned - e.g. by reference to t h e i r gross turnover -"cost funding" or what has sometimes been c a l l e d the 58 "f i x e d key" method; (d) The i n c l u s i o n of a mark-up i n the p r i c e of products sold to an a f f i l i a t e by the company which incurs the cent r a l costs. 34 Methods (b), (c) and (d) can be categorized as " i n d i r e c t methods". Revenue Canada's perspective As the OECD 1984 Report indicates, the d i r e c t method has "the advantage that economic r e a l i t y and f i s c a l p r i n c i p l e s are 35 r e f l e c t e d as f u l l y as possible", and also would be most suitable to conform to the arm's length p r i n c i p l e that prices f o r services performed between associated corporations should be those which 36 would be paid between unrelated p a r t i e s . In addition, t h i s method i s very convenient f o r tax aut h o r i t i e s , since i t makes i t possible to achieve the highest degree of separation and passing on of cost i n proportion to the 37 benefit received and the danger of dupl i c a t i o n or double dipping 38 and the p o s s i b i l i t y of the s h i f t i n g of p r o f i t s w i l l be reduced. Although Revenue Canada does not express i t s preference i n IC 87-2, considering i t s "transaction-by-transaction" approach, i t seems to prefer the d i r e c t method to i n d i r e c t method. However, Revenue Canada seems to f u l l y r e a l i z e that the proportion of the value of the benefit a r i s i n g to the various relevant e n t i t i e s cannot be quantified except on an approximate 39 or estimated basis, and there may be the cases where i t would impose an i n t o l e r a b l e administrative burden on MNCs to i n s i s t on 59 40 the use of the d i r e c t method. In other words, the amounts to be determined are not p r e c i s e l y ascertainable, but are rather, a reasonable approximation i n most cases. Therefore, i n order to augment tax compliance i n the long run, Revenue Canada should be f l e x i b l e and promote the acceptable method which i s compatible with the taxpayer's s i t u a t i o n , and i s supported by documentation created and maintained by the taxpayer. Accordingly, as IC 87-2 states, where the taxpayer's basis of a l l o c a t i o n i s based on a comprehensive review of the central expenses c a r r i e d out i n advance of the a l l o c a t i o n , and that basis i s a v a i l a b l e f o r examination by Revenue Canada, i n d i r e c t methods 41 could be accepted f o r tax purposes. In t h i s context, i t i s strongly recommended that the Canadian taxpayer should maintain the appropriate supporting documentation, and be cooperative i n providing the necessary information required by Revenue Canada. Although MNCs have complained that a complete recording and analysis of the relevant a c t i v i t i e s would impose an i n t o l e r a b l e administrative burden on them, and such a heavy burden would l i m i t the d e d u c t i b i l i t y i n substance, Revenue Canada seems to understand such documentation requirements should be compatible with the taxpayer's a b i l i t y , and taxpayers might be able to know the d e d u c t i b i l i t y of the expense by the "advance r u l i n g " system. Therefore, i t can be said that i n p r i n c i p l e Revenue Canada's approach i s reasonable. As to what i s the acceptable method, IC 87-2 b r i e f l y states: 60 The basis of a l l o c a t i o n should r e s u l t i n costs being shared i n proportion to the benefits received, for example, the a l l o c a t i o n of costs of a ce n t r a l i z e d department based on estimate of time spent on duties performed f o r each e n t i t y . 43 Further consideration to be given by taxpayers could be deduced from the OECD reports. I t should be noted that Revenue Canada's attitude against the taxpayer who was un-cooperative or f a i l e d to provide the information requested i s f a i r l y s t r i c t . The requests f o r the mutual agreement procedure by such a taxpayer may not be accepted 44 by Revenue Canada. Direct method As the OECD Report suggests, to determine the amount of consideration under the arm's length p r i n c i p l e by t h i s method, "the open market value of the service rendered would have to be 45 established." Unlike i n the case of transfer of goods, the OECD Report suggests that information about the pric e s paid i n other transactions of a s i m i l a r kind between unrelated p a r t i e s should be looked f o r at f i r s t ; then, i n the absence of such information, i t may be necessary to look at prices charged for si m i l a r services to unrelated p a r t i e s by the corporation which provided 46 the intra-group service i n question. I t should be borne i n mind by tax aut h o r i t i e s that, even i f the comparable open market p r i c e i s available, such a comparable p r i c e i s not always an appropriate basis for the arm's length 61 p r i c e because of the uniqueness of functions performed by the group service center, and so on, deliberate consideration based on p a r t i c u l a r facts and circumstances of the case should be 47 given. Where the comparable open market prices are not available, as the OECD Report suggests, "a cost oriented method may be 48 h e l p f u l i n providing an approximation to arm's length p r i c e s . " In t h i s cost oriented method, since an independent supplier of service i n an arm's length s i t u a t i o n would seek to recover a l l relevant costs incurred, both d i r e c t and i n d i r e c t costs should be 49 included. I t i s apparently d i f f i c u l t to determine the i n d i r e c t costs a c t u a l l y r e l a t e d to a p a r t i c u l a r service, and an apportion-ment of the t o t a l relevant costs of the supplier have to be made 50 on some reasonable basis. On t h i s point, a cost oriented method i n f a c t requires s i m i l a r considerations as i n the i n d i r e c t methods. In addition, i f the cost could not be met by the re c i p i e n t of the services, t h i s cost oriented method would not be 51 appropriate f o r use i n a r r i v i n g at the arm's length p r i c e . In d i r e c t methods Where i t i s d i f f i c u l t or inappropriate for a MNC to use the direct-charging method, the MNC may use i n d i r e c t methods. These methods also should conform to the arm's length p r i n c i p l e . Whereas i n the d i r e c t method, the question i s only whether the amount charged i s an arm's length amount, i n i n d i r e c t methods, the question i s not only whether the amount charged i s an arm's length amount, but also whether the method i s an arm's length 62 52 method. To be an arm's length method, the method should correspond to the arrangements which would be made between 53 unrelated p a r t i e s . However, i t should be strongly observed by tax a u t h o r i t i e s , as the OECD 1984 Report suggests, that i t would be wrong to ignore completely the s p e c i a l s i t u a t i o n of MNCs and the fact that these methods are not applied, or are very seldom applied, between unrelated p a r t i e s ought not to lead one to conclude that they necessarily produce charges which must be regarded as not at arm's length. 54 The OECD 1984 Report also suggests: The most appropriate i n d i r e c t method i s generally recognized to be one which i s based on sharing among the b e n e f i c i a r i e s , i n proportion to the benefits received or expected, the actual costs incurred i n providing the services. 55 I t has to be recognized, as stated e a r l i e r , that a tax authority has a tendency that while i n determining the c h a r g e a b i l i t y of central management expenses incurred by a parent company which i s situated i n i t s j u r i s d i c t i o n to i t s subsidiaries abroad, i t may make the parent company charge as much as possible by using the "general benefit t e s t " , i n determining the d e d u c t i b i l i t y of the expenses charged by a foreign parent company to i t s subsidiary which i s situated i n i t s j u r i s d i c t i o n , i t may l i m i t the amount deductible as small as possible by using the " s p e c i f i c benefit t e s t " . 5 6 T h i s double standard has been producing 57 economic double taxation. Since the main concern of tax a u t h o r i t i e s , i n other words, the main reason why tax authorities are reluctant to accept 63 i n d i r e c t methods, i s the danger of double dipping, i . e . , double charge or double deduction and the s h i f t i n g of p r o f i t s by a MNC through i t s intra-group arrangements, i f a MNC sets up the arrangement which could remove the tax a u t h o r i t i e s ' fear, i t can be expected that tax authorities would accept i n d i r e c t methods 5 8 more e a s i l y . From t h i s viewpoint, the OECD 1984 Report suggests the following p r i n c i p l e s which should be observed by MNCs i n making cost sharing or cost funding arrangements: (a) The method should be l a i d down i n c l e a r l y formulated and binding contracts, concluded i n advance; (b) These contracts should be observed consistently over several years; (c) The contracts should apply to those associated enterprises which w i l l benefit, or from an ex ante point of view may be expected to benefit, from the a c t i v i t i e s ; (d) The costs of the relevant a c t i v i t i e s should be determined on the basis of generally-accepted accounting p r i n c i p l e s (such as those underlying the consolidated group's annual report); (e) The group members which share the costs should have f u l l access to the services concerned; (f) Where the services are provided to t h i r d p a r t i e s as well as to a f f i l i a t e s and, exceptionally, the remuneration from t h i r d p a r t i e s cannot s a t i s f a c t o r i l y be used as the basis for the use of a direct-charge method then the costs chargeable should be reduced by the remuneration received from the t h i r d p a r t i e s ; (g) The contracting group members must not pay f o r the services concerned i n any other way; (h) A l t e r a t i o n s i n the r e s p o n s i b i l i t i e s and a c t i v i t i e s of group members which influence t h e i r benefit p o s i t i o n should be taken account of as soon as possible i n the contracts (changes i n p r o f i t a b i l i t y would not normally j u s t i f y amendment of the contract). 5 9 64 4 . AMOUNT OF CONSIDERATION Arm's length p r i n c i p l e As stated e a r l i e r , the general p r i n c i p l e to be followed i s that p r i c e s f o r services performed between associated corporations should be those which would be paid between unrelated p a r t i e s f o r s i m i l a r s e r v i c e s . 6 0 P r o f i t mark-up In determining the reasonable arm's length amount of the charge, the problem i s whether or not the charge should include a p r o f i t mark-up. IC 87-2 states: The amount charged by the non-resident should not exceed the expenses that may be allocated to the Canadian taxpayer as set out i n 25(b) and (c)above, i . e . , the expenses incurred s o l e l y for the benefit of the Canadian taxpayer and a reasonable share of expenses that are incurred for the benefit of a number of companies or the group as a whole... Generally, there i s no p r o f i t element i n shared costs charged to Canadian branches and s u b s i d i a r i e s . 61 However, Revenue Canada may accept the p r o f i t element on charge and allow the t o t a l charge deductible where a reasonable mark-up on charges for services from a non-resident related company which i s i n the business of providing such services has been made. 62 Contrary to Revenue Canada's p r i n c i p l e , the OECD Report suggests that the general p r i n c i p l e would be to expect the charge 65 to be based on costs with an appropriate mark-up, since i n an arm's length s i t u a t i o n , an independent corporation would normally charge f o r the services i t provided i n such a way as to recover 63 not only i t s cost but also an element of p r o f i t . According to the OECD Report, a p r o f i t mark-up i s always appropriate i n the following three cases: (a) The provision of such services i s one of the main a c t i v i t i e s of a corporation; (b) The provision of such services i s not a main part of i t s business, but the corporation i s p a r t i c u l a r l y capable of supplying such services and the value of the services to the re c i p i e n t i s considerably greater than the cost; (c) The cost of the services represents a substantial proportion 64 of the expenses of the rec i p i e n t ' s business. On the other hand, i t has to be recognized, as the OECD 1984 Report also indicates, that i n p r a c t i c e the function and s i t u a t i o n of service departments of MNEs may d i f f e r considerably from those of independent businesses performing the same kinds of service. 65 The report continues: One important difference i s that i n many cases group service departments may render services to group members only. The function of a department of t h i s kind i s e s s e n t i a l l y to reduce the costs of the group and thus to a s s i s t the group as a whole to make a p r o f i t , rather than, as i n the case of an independent business, to make a p r o f i t for i t s e l f . 66 Therefore i t may be reasonable to accept that the company could not seek to recover more than i t s costs from the other members of the group i n such cases, and as a c o r o l l a r y of the 66 above-mentioned arm's length p r i n c i p l e , i f the service i s usually performed between unrelated p a r t i e s on a cost-price basis, a p r o f i t mark-up need not be made on charges of intra-group 67 services. Despite the above-mentioned differences i n approach between Revenue Canada and the OECD reports, i n pra c t i c e , the f l e x i b l e a t titude of Revenue Canada seems to have found s a t i s f a c t o r y solutions f o r taxpayers. As to the differences i n approach between the relevant tax au t h o r i t i e s , the f i n a l s o l u t i o n of double taxation would depend on mutual agreement procedures, or follow-up meetings to simultaneous examination between tax a u t h o r i t i e s . 6 8 5 . SUMMING UP Canadianism I t might be an i n t e r e s t i n g phenomenon that whereas the U.S. IRS has been t r y i n g to make the U.S. parent companies of MNCs charge the central management expenses to t h e i r Canadian sub s i d i a r i e s as much as possible, Revenue Canada has been s t r i c t l y i n t e r p r e t i n g " r e a l benefits", and has been reluctant with the d e d u c t i b i l i t y of such expenses paid by the Canadian s u b s i d i a r i e s . Revenue Canada's perspective on management expenses of MNCs might be r a t i o n a l i z e d by the fa c t that since a number of Canadian large companies are subsidiaries of the U.S.-based MNCs, a large amount of management fees have been paid by the Canadian taxpayers to the U.S. or other foreign companies and 67 s i g n i f i c a n t portion of such payments are abused for the purpose of maximizing o v e r a l l after-tax p r o f i t s of MNCs: for example as a means of the s h i f t i n g of p r o f i t s or double dipping. Although the attitude of Revenue Canada has been c r i t i c i z e d by MNCs and tax p r a c t i t i o n e r s , as so s t r i c t that sound business 6 9 a c t i v i t i e s of MNCs have been dis t o r t e d ; i n the tax community of Canada, there are opinions that the present Revenue Canada's approach i s encouraging foreign-based MNCs to truncate t h e i r Canadian operations and do the work outside Canada. According to t h e i r opinion, present tax treatments of management fees or expenses are too generous, since no withholding taxes are imposed on the payments under subsection 212(4) of the Income Tax Act and 70 such payments are deductible i n Canada i f reasonable. As to the payments to the U.S. parent companies, thanks to the new Canada -U.S. Income Tax Convention, any management fees are not subject 71 to withholding taxes. In the view of t h e i r "Canadianism", Canada should not permit the Canadian subsidiaries deductions for a l l expenses reimbursed to the foreign parent companies when those functions could and should o r d i n a r i l y be performed i n 72 Canada. They also suggest that whereas Revenue Canada should grant benefit of the doubt to Canada-based MNCs, t i g h t up the room for the abusive use of management fees by foreign-based 73 MNCs, within discretionary power of Revenue Canada. However, such a p a t r i o t i c approach does not conform to the 74 OECD Model Double Taxation Convention and would make MNCs 75 manipulate the transfer prices i n other types of transactions. 68 Part XIII tax By v i r t u e of paragraph 212(1)(a) of the Income Tax Act, management or administration fees or charges that a resident of Canada pays to non-resident i s subject to 25 percent, subject to reduction by the tax conventions, withholding tax. On the other hand, subsection 212 (4) provides the case which excludes c e r t a i n management fees from Part XIII tax. In the case of intra-group management fee, i f the amount was a reimbursement of a s p e c i f i c expense incurred by the non-resident for the performance of a service, and the service performed by the non-resident was f o r the benefit of the payer, and to the extent that such payment i s reasonable i n the circumstances, such 76 an intra-group management fee i s not subject to Part XIII tax. Accordingly, only the excess over the above-mentioned amount w i l l be subject to Part XIII tax and w i l l be disallowed under section 77 67 and sub-section 69(2) as an expense of the Canadian payer. As to the reasonableness, t h r same c r i t e r i a as under Part I of the Income Tax Act are to be applied. New Canada-U.S. Income Tax Convention treats management fees as i n d u s t r i a l , commercial or business p r o f i t s , and by v i r t u e of A r t i c l e VII of the convention, the management fees paid by the Canadian resident to the U.S. resident i s not subject to withholding tax to the extent i t i s reasonable and deductible under Part I of the Income Tax Act, v i c e versa. Therefore, as IC 87-2 states: 69 As a consequence of applying the terms of the 1980 convention to payments a f t e r 1984, the previous importance of the management fee issue have been greatly reduced. 78 70 SUBCHAPTER I I I - FOOTNOTES 1 The A l l o c a t i o n of Central Management and Service Costs, Transfer P r i c i n g and Multinational Enterprises: Three  Taxation Issues, Report of the OECD Committee on F i s c a l A f f a i r s (1984), at para. 3 2 Transfer P r i c i n g and Multinational Enterprises. Report of the OECD Committee on F i s c a l A f f a i r s (1979), at para. 139 3 Supra. note 1, at para. 16 4 Supra. note 1, at para. 18 5 Supra, note 2, at para. 143 6 Supra. note 2, at para. 141 7 Revenue Canada, International Transfer P r i c i n g and Other International Transactions, Information C i r c u l a r 87-2 (1987), at para. 26 8 Supra. note 1, at para. 4 9 Supra. note 2, at para. 151 10 Supra, note 7, at para. 26 11 Supra. note 2, at para. 154 12 Supra. note 2, at para. 154 13 Supra, note 2, at para. 156 14 Supra. note 1, at para. 23 15 Supra. note 1, at para. 34 16 Supra. note 1, at para. 34 17 Supra. note 1, at para. 35 18 Supra, note 1, at para. 37 19 Supra. note 1, at para. 38 20 Supra. note 1, at para. 39 21 Supra. note 1, at para. 39 71 22 Supra, note 2, at para. 156 23 Supra. note 7, at para. 26 24 Supra. note 1, at para. 43 25 Supra. note 2, at para. 146 26 Supra. note 2, at para. 152 27 Supra. note 2, at para. 152 28 Supra, note 2, at para. 157 29 Supra. note 2, at para. 153 30 Supra, note 2, at para. 157 31 Supra. note 2, at para. 159 32 Supra. note 1, at para. 25 33 Supra, note 1, at para. 25 34 Supra. note 1, at para. 45 35 Supra. note 1, at para. 53 36 Supra. note 2, at para. 160 37 Supra. note 1, at para. 54 38 Supra. note 1, at para. 56 39 Supra. note 1, at para. 59 40 Supra, note 1, at para. 60 41 Supra. note 7, at para. 27 42 Supra. note 1, at para. 60 43 Supra. note 7, at para. 27 44 Revenue Canada, Requests for Competent Authority Considera-t i o n - Double Taxation Issues, Information C i r c u l a r 71-17R2 (1984), at para. 10 45 Supra. note 2, at para. 164 46 Supra, note 2, at para. 164 72 47 The U.S. IRC Regulation 1.482-2(b)(3) 48 Supra. note 2, at para. 165 49 Supra. note 2, at para. 165 50 Supra. note 2, at para. 165 51 Supra. note 2, at para. 169 52 Supra. note 2, at para. 63 53 Supra, note 1, at para. 63 54 Supra. note 1, at para. 63 55 Supra. note 1, at para. 65 56 Supra. note 1, at para. 30 57 Supra. note 1, at para. 31 58 Supra, note 1, at para. 67 59 Supra. note 1, at para. 67 60 Supra, note 2, at para. 160 61 Supra. note 7, at para. 30 62 Supra. note 7, at para. 30 63 Supra. note 2, at para. 167 64 Supra. note 2, at para. 168 65 Supra f note 1, at para. 81 66 Supra. note 1, at para. 81 67 Supra. note 1, at para. 77 68 Supra. note 1, at para. 86 69 N. Boidman, Canada-US Intercompany (and other) Taxation Issues, Report of the Proceedings of the T h i r t y - F i f t h Tax  Conference. Canadian Tax Foundation (1983), at 351-352 70 J . S. Peterson, International Transfer P r i c i n g : A Canadian Perspective, Report of the Proceedings of the T h i r t y - F i r s t  Tax Conference. Canadian Tax Foundation (1979), at 466 71 A r t i c l e VII of the Canada-U.S. Income Tax Convention. The 73 same approach i s adopted i n the Canada-U.K. Income Tax Convention ( A r t i c l e VII). 72 Supra, note 70, at 467 73 Supra, note 70, at 468-469 74 A r t i c l e 24 of the OECD MOdel Double Taxation Convention 75 Supra, note 1, at para. 13 76 Revenue Canada, Income Tax Act: Management or Administration Fees paid to Non-Residents, Interpretation Bulletin-468 (1981), at para. 4 77 Ibid, para. 8 78 Supra. note 7, at para. 33 74 SUBCHAPTER IV TRANSFER OF TECHNOLOGY - USE OF INTANGIBLE PROPERTY -1. INTRODUCTION The research and development ("R & D") a c t i v i t i e s are of v i t a l importance for MNCs to keep t h e i r growth and p r o f i t a b i l i t y i n a world market. E s p e c i a l l y i n technology intensive industries, the R & D a c t i v i t i e s are ine v i t a b l e and indispensable to continue t h e i r existence as economic e n t i t i e s . Thus MNCs are spending a huge amount of R & D expenses. 1 In a MNC, a parent company usually, but not always, undertakes R & D , and makes the re s u l t s a v a i l a b l e to the other members of the group, and recovers the expenses from such members. There are a number of ways to make availa b l e the r e s u l t of R & D to the members, and to finance (or recoup) R & D expenses. Such ways can be categorized as follows: (a) The parent company or other company which undertook R & D makes ava i l a b l e the re s u l t s to the other members of the MNC by l i c e n s i n g agreements and receives the royalty or fee for the use of patents or know-how, etc.; (b) The parent company or other company which undertook R & D makes a "cost contribution arrangement" with other members of the 75 MNC (in advance). Under t h i s arrangement, the member of the MNC pays i t s share of the expenditure to finance R & D and w i l l be e n t i t l e d to a f a i r share of the r e s u l t s of the R & D ; (c) Where the R & D i s undertaken at the s p e c i f i c request of one 2 member of the MNC, the expense i s borne by that member. Since MNCs are i n a po s i t i o n to adopt any measure which benefits them, they might use the above-mentioned l i c e n s i n g agreements or cost contribution arrangements as vehicles to a l l e v i a t e the o v e r a l l tax burden as a group. For example, by manipulating the p r i c i n g p o l i c y of l i c e n s i n g agreements or the basis of cost a l l o c a t i o n , a MNC could s h i f t the p r o f i t from one en t i t y to the other i n the group. Or, R & D expenses which are shared by the subs i d i a r i e s might be included i n the p r i c e of the 3 products which are purchased by the sub s i d i a r i e s . On the other hand, since the treatments of l i c e n s i n g agreements or cost contribution arrangements or R & D expense for tax purposes vary from country to country, even i n the case where the MNC has no intention of avoiding or evading tax, i t s p r i c i n g p o l i c y or cost a l l o c a t i o n basis would not necessarily provide an acceptable basis for the determination of taxable p r o f i t s for the 4 relevant tax au t h o r i t i e s . In t h i s subchapter, the l i c e n s i n g agreements, i . e . , royalty payments f o r patents or know-how and cost contribution arrange-ments w i l l be discussed. 76 2. LICENSING AGREEMENTS - ROYALTY PAYMENT FOR PATENTS OR KNOW-HOW DEVELOPED BY ONE MEMBER OF A MNC FOR OTHER MEMBERS OF THE MNC -Use of intangible property vs. outright t r a n s f e r of intangible  property Before looking into the arm's-length p r i n c i p l e i n l i c e n s i n g agreements, i t i s necessary to d i s t i n g u i s h between the royalty payment f o r patents and the payment for outright t r a n s f e r of patents. 5 The roya l t y i s the payment made to the owner of the property for the r i g h t to use such property for a given period of time, and has a nature of current expense and i s deductible i n the taxation year i n which the payment i s made. On the other hand, the payment f o r outright t r a n s f e r of intangible property i s c a p i t a l outlay and cannot be deducted i n the taxation year i n which the payment i s made and subject to amortization under the Income Tax A c t . 6 According to the case laws, there may be a case that even a 7 lump sum payment can be royalty and i t can be said that there i s no standpoint to d i s t i n g u i s h and i t i s necessary to judge c a r e f u l l y under each circumstances. The same arm's length p r i n c i p l e as i n the case of transfer of goods w i l l apply to the outright t r a n s f e r of intangible o property, mutatis mutandis. 77 Know-how fee vs. service fee As the OECD Report indicates, i t i s also necessary to di s t i n g u i s h the transfer making available the use of intangible property to another party, from technical assistance or si m i l a r a c t i v i t i e s or s i m i l a r a c t i v i t i e s which constitute personal 9 services. E s p e c i a l l y , "know-how" needs ca r e f u l consideration, since unlike a patent, which i s a l e g a l l y protected monopoly r i g h t to an invention, a know-how i s a les s precise concept. According to the commentary on A r t i c l e 12 of the OECD Model Double Taxation Convention, i n the know-how contract the grantor i s not required to play any part himself i n the app l i c a t i o n of the formulae of the know-how by the licensee, and the grantor does not guarantee the r e s u l t thereof. On the other hand, i n the contract for the provision of services, one of the parties undertakes to use the customary s k i l l s of h i s c a l l i n g to execute work f o r the other p a r t y . 1 0 However, i t i s very d i f f i c u l t to draw a borderline between these two types of contracts, since most of know-how contracts include a service element 1 1 and es p e c i a l l y , MNCs often make "package deals". J u s t i f i c a t i o n of benefit To make the payment for the use of the patent or know-how ("royalty") deductible, f i r s t of a l l , a r e a l benefit has to be conferred or could be reasonably expected at the time of the 78 12 conclusion of the l i c e n s i n g agreement. In other words, to j u s t i f y the payment for tax purposes, as the OECD Report suggests, i t has to be demonstrated that the patent or know-how i n question i s i n fact useful for the p a r t i c u l a r needs of the corporation paying for them and that a r e a l benefit i s thereby conferred. 13 Arm's length p r i n c i p l e i n l i c e n s i n g agreements A f t e r the j u s t i f i c a t i o n of benefits i s made, the t e s t of the arm's length p r i n c i p l e has to be met. The general p r i n c i p l e i s that the l i c e n s i n g agreements between one member which undertook R & D and owns the patent or know-how, usually a parent company, and the other member of the MNC should correspond to those that would be made between unrelated p a r t i e s i n terms of the form and amount of the 14 consideration. F i r s t , the payments i n l i c e n s i n g agreements i n non-arm's length s i t u a t i o n s should be i n a form which i s compatible with the form which would be adopted i n transactions between unrelated 15 p a r t i e s under the s i m i l a r circumstances. Therefore, where the royalty payment i n question may take a form of recurrent payments, or degressive payments, or lump sum payments, i f such a form would be usual between unrelated p a r t i e s , the payment would be acceptable to tax a u t h o r i t i e s . 1 6 Second, the amount of an arm's length consideration should be the amount that would have been paid by an unrelated party for the same or s i m i l a r intangible property under the same or si m i l a r circumstances. That i s to say, as i n the t r a n s f e r of goods, the comparable uncontrolled p r i c e method w i l l apply to the use of intangible property. Where the same developer made a l i c e n s i n g agreement with unrelated p a r t i e s involving the same or s i m i l a r intangible property under the same or s i m i l a r condition, t h i s comparable uncontrolled p r i c e method would be the best method to 18 c a l c u l a t e the arm's length p r i c e . However, i n practice, i t i s very d i f f i c u l t to f i n d s a t i s f a c t o r y comparable open market transactions, since the owner of the intangible property i n a MNC usually does not make i t available to unrelated p a r t i e s and such 19 an intangible property i s a monopoly r i g h t . The o f f e r s to unrelated p a r t i e s or the genuine bids of competing licensees or the p r i c e i n sub-licensing contract by the licensee to the 20 unrelated party might be useful data for t h i s method. However, the OECD Report states: I t i s considered that i t i s u n l i k e l y to be possible to construct any standard rates, such as a c e r t a i n percentage of sales, since even within a given sector of industry i t i s extremely d i f f i c u l t to discern any t y p i c a l rate or range of rate. 21 Revenue Canada also r e a l i z e s such a d i f f i c u l t y . Paragraph 45 of IC 87-2 states: The best can be expected i s to draw comparisons with royalty rates i n the same industry or a s i m i l a r industry, involving r e l a t i v e l y s i m i l a r products, s i m i l a r market conditions and s i m i l a r l i c e n s i n g arrangement. Where the tax a u t h o r i t i e s t r y to a r r i v e at an acceptable p r i c e i n intra-group l i c e n s i n g contracts by using the evidence 80 provided by the "comparable " transaction, i t i s necessary to 22 take a l l the circumstances into account. Paragraph 46 of IC 87-2 l i s t s the following items as factors to be taken into account: (a) P r e v a i l i n g rates i n the industry: Those rates can be obtained from the pub l i c a t i o n and market surveys. Since i t cannot be always said that s i m i l a r industries have s i m i l a r rates, the discrepancy from the average industry rate may not necessarily indicate the unreasonable rate; (b) Terms of the license, including geographic l i m i t a t i o n and exclusive r i g h t s : Whereas some l i c e n s i n g agreements may include the r i g h t s to make, use and s e l l , the others may include only one of these. The payments therefore should be d i f f e r e n t . The payment for an exclusive license should be higher than that for a 23 non-exclusive l i c e n s e ; (c) S i n g u l a r i t y of the invention and the period for which i t i s l i k e l y to remain unique: The nature of a patent a f f e c t s the payment considerably. The royalty f o r the "beakthrough" patent should be higher than the royalty for the patent which i s designed to improve the e x i s t i n g patent, or for which substitutes 24 are r e a d i l y a v a i l a b l e ; (d) Technical assistance, trade-marks and "know-how" provided along with access to the patent: Unless the l i c e n s o r invoices a fee f o r assistance, trade-mark and know-how separately, royalty under such a l i c e n s i n g agreement might be higher than ordinary 25 cases; (e) P r o f i t s anticipated by the licensee: As a c o r o l l a r y , the gross p r o f i t margin on products under the license should be 81 higher than that on other products not protected by the patent or know-how; (f) Benefits to the l i c e n s o r a r i s i n g from the sharing information on the experience of the licensee: I f the licensee i s obliged to impart further improvement of the invention under the l i c e n s i n g 2 6 agreement, t h i s should influence the amount of the payment. In addition to the above-mentioned items, the degree and duration of protection afforded to the property under the laws of 27 the relevant countries might be relevant factors. Where a comparable uncontrolled transaction cannot be found, other methods have to be used to f i n d the reasonable arm's length 28 p r i c e for tax purposes. Since Revenue Canada does not state the other methods to be applied i n IC 87-2, i t might be appropriate to deduce them from the OECD Report. One i s the " p r o f i t comparison approach". This method i s to make a pragmatic appraisal of the trend of a company's p r o f i t s over a long period i n comparison with those of other unrelated p a r t i e s engaged i n the same or s i m i l a r a c t i v i t i e s and operating 29 i n the same area. However, i n most cases the taxpayer could j u s t i f y h i s unusual p r o f i t with many reasons, and as the OECD Report indicates: I t would be very d i f f i c u l t to i s o l a t e the respective p r o f i t s of the l i c e n s o r and licensee since a number of r i g h t s may be under license at the same time for manufacturing of the d i f f e r e n t products and since accounting methods i n the countries concerned may d i f f e r fundamentally. 30 Therefore, t h i s method could be only useful to indicate 82 whether the consideration charged for the use of intangible property may or may not be reasonable. The other i s the "cost" method. This method make the cost of R & D basis to consider an arm's length royalty rate. However, the actual open market p r i c e of intangible property may not be rel a t e d i n a consistent manner to the costs of developing i t and the p r i c e of the successful invention may often include 31 the cost of unsuccessful R & D . In addition, i t i s d i f f i c u l t to determine s p e c i f i c amounts of costs involved i n R & D for a p a r t i c u l a r intangible property, e s p e c i a l l y when R & D a c t i v i t i e s are performed i n a group on a large scale and f o r the various 32 purposes. Therefore, the cost should not form the only basis for the arm's length royalty, but despite the above-mentioned d i f f i c u l t i e s , the OECD Report indicates: There may be cases where the cost-oriented method gives some guidance, at le a s t as regards the lower l i m i t for the l i c e n s o r ' s p r o f i t i n normal circumstances. 33 The U.S. IRS seems to adopt t h i s method as a secondary method. These other methods could be at le a s t useful as means to v e r i f y a p r o v i s i o n a l l y acceptable p r i c e a f t e r other methods have been applied, and i t might be necessary to use more than one method i n a r r i v i n g at a s a t i s f a c t o r y approximation to an arm's 34 length p r i c e . Double dipping Another general p r i n c i p l e to determine the acceptable arm's length royalty i s that there should be no double deduction or 83 35 double charge f o r the use of the intangible property. For example, the following cases could be assumed: (a) Where the company paying royalty for the p a r t i c u l a r patent to i t s foreign parent company acquires the product made under the patent i n f i n i s h e d state, the p r i c e for those goods might include the R & D expense of the patent; (b) The company which shared the R & D expense f o r the p a r t i c u l a r patent with i t s foreign parent company through the cost contribution arrangement might make a l i c e n s i n g agreement for the patent; (c) The parent company may charge i t s foreign subsidiary management fees which includes the s a l a r i e s of the engineers, which were already included i n the c a l c u l a t i o n of the R & D expense i n the cost contribution agreement with that subsidiary; (d) Where a MNC has two foreign subsidiaries i n the same country, one of which i s a manufacturing e n t i t y and the other a marketing e n t i t y , the parent company might charge both subsidiaries r o y a l t i e s . Revenue Canada seems to pay much attention i n t h i s problem. 3. COST CONTRIBUTION ARRANGEMENTS FOR R & D EXPENDITURE AMONG  MEMBER COMPANIES OF MNCS Cost contribution arrangement As a means to make available the r e s u l t of R & D a c t i v i t i e s 84 to the associated companies and recoup the R & D expenditure from them, some MNCs use the "cost contribution arrangement" instead of l i c e n s i n g agreements. According to the OECD Report, t h i s cost contribution arrangement can be roughly categorized into two types: One i s the "cost sharing arrangement" under which members of a MNC agree to share the actual costs and r i s k s of R & D undertaken f o r the benefit or expected benefit of each of them, and would i n return be e n t i t l e d to i t s f a i r share of any usable 3 6 r e s u l t s of the R & D. The other i s the "cost funding arrangement" under which members of a MNC contribute i n a more general way to the R & D expenditures of the MNC and would be 3 7 e n t i t l e d to use the r e s u l t s . The difference between these two types i s that under the cost funding arrangement, the contribution would take the form of a generalised fee, and would not be r e l a t e d to the actual cost of R & D a c t i v i t i e s , and the actual r e s u l t s of R & D may be owned by a single company, usually 3 8 a parent company. The cost contribution arrangement has several advantages for MNCs: For example, each member company has a better chance to get access to the benefits from research programs of a large magnitude i n return for reimbursing only a r e l a t i v e l y small share of the costs. This arrangement provides a simpler and more equitable method than intra-group l i c e n s i n g agreements, and above a l l , the company which undertakes R & D can finance the cost i n advance or recoup rapi d l y and a l l e v i a t e the r i s k to be 3 9 involved. For the tax a u t h o r i t i e s , however t h i s cost contribution 85 arrangement presents a number of d i f f i c u l t i e s . Their concern i s that a MNC could s h i f t t h e i r p r o f i t among i t s members by an a r b i t r a r y a l l o c a t i o n of cost, by double dipping, or by tr e a t i n g c a p i t a l expenses as current expenses. Considering the above-mentioned advantages, i t i s necessary to accomodate the existence of the cost contribution arrangement 40 of MNCs. However, i t i s important for tax au t h o r i t i e s to s c r u t i n i z e the d e d u c t i b i l i t y or chargeability of the expenses under the cost contribution arrangements. In the U.S., i f a p a r t i c u l a r cost sharing arrangement meets the conditions provided by the IRC Regulation, the taxpayer w i l l be allowed for tax purposes to charge or to deduct as expenses 41 the actual cost involved. In Canada, the d e d u c t i b i l i t y of R & D expenses under Part I of Income Tax Act i s determined by the following p r i n c i p l e s , J u s t i f i c a t i o n of benefits IC 87-2 states: The Canadian taxpayers obviously must be i n a p o s i t i o n to benefit from the R & D , i f not immediately at l e a s t p o t e n t i a l l y , by having a genuine and substantial i n t e r e s t i n the r e s u l t s which the research might produce. 42 That i s to say, the R & D a c t i v i t i e s have to be c l o s e l y 43 rela t e d to the s p e c i f i c needs of the p a r t i c i p a n t s . As i n the case of the l i c e n s i n g agreement, looking at the benefits conferred or conferrable i s a key consideration. 86 J u s t i f i c a t i o n of cost incurred The cost of research performed at the s p e c i f i c request of a p a r t i c u l a r company should be b i l l e d to the company and should not 44 be included i n the cost incurred, and where a MNC has receipts by l i c e n s i n g to unrelated parties, those amounts should be 45 deducted from the cost. I f there i s an excess of the r o y a l t i e s over gross costs i n any year, such excess would be d i s t r i b u t e d or 46 credited. Not only d i r e c t costs but also some i n d i r e c t costs 47 could be allocated, but s t r i c t i n t e r p r e t a t i o n of the notion of r e a l benefits i s necessary. A l l o c a t i o n of costs (benefits) on a reasonable basis The costs of R & D have to be allocated i n a f a i r and equitable way to the p a r t i c i p a n t of a cost contribution 48 arrangement. There i s no formula to a l l o c a t e and MNCs have been a l l o c a t i n g the costs i n proportion to the expected benefit, or 49 the proportionate turnover of the p a r t i c i p a n t . Although such "rules of thumb" might be reasonable i n some cases, Revenue Canada may not regard sales, production or p r o f i t s as e s t a b l i s h i n g a reasonable basis for sharing cost and, such 50 formula w i l l have to be s c r u t i n i z e d by the tax a u t h o r i t i e s . IC 87-2 does not specify any basis of a l l o c a t i n g as being preferable. I t indicates that "the method u t i l i z e d should be appropriate to the p a r t i c u l a r circumstances i n each case" and suggests a possible approach, that i s , to categorize the R & D by the l i n e of business and product group, then to a l l o c a t e the current expenses 87 among those companies who currently deal i n the p a r t i c u l a r product group. 51 Where a MNC allo c a t e s the benefit from t h i r d p a r t i e s such as r o y a l t i e s f or patents paid by the t h i r d party, the same consideration would have to be given. Arm's length p r i n c i p l e The cost contribution arrangements are uncommon between unrelated p a r t i e s . However, the terms and conditions of cost contribution arrangement of MNCs must be comparable to those which would have been adopted by the unrelated pa r t i e s under 52 s i m i l a r circumstances. For example, as the OECD Report indicates, i f the pa r t i c i p a n t of an arrangement has not benefited from R & D concerned over a long period of time, t h i s might indicate that the R & D was not ca r r i e d out i n the i n t e r e s t and 53 for the benefit of that p a r t i c u l a r company. Since, i n such circumstances an independent company would not be l i k e l y to 54 p a r t i c i p a t e i n the arrangement. The treatment of p r o f i t element i n contribution According to IC 87-2, i t i s assumed that under a cost sharing arrangement the resources are pooled f o r convenience or economy, and each p a r t i c i p a n t would bear i t s f a i r share of the net costs, i n return for a f a i r share of the usable r e s u l t s of R 55 & D. Therefore, "there would be no mark-up or p r o f i t element on the R & D a c t i v i t i e s " 5 6 u n d e r such an arrangement. However, as the OECD Report indicates, there might be 88 l i m i t e d room for p r o f i t elements as a reward for the a c t i v i t i e s made by the company which undertook the R & D i n organizing the 57 relevant research project. Where the developer i s not a parent company of a MNC, but a separately incorporated research entity which would not use the r e s u l t s of the R & D for i t s own purposes, such a research company would o r d i n a r i l y be required and allowed to charge cost plus a p r o f i t mark-up to r e f l e c t i t s 58 e f f o r t s at organizing and managing the research. In the case where a separately incorporated research e n t i t y other than a parent company undertakes the R & D , the attitude of Revenue Canada on the p r o f i t mark-up i s not c l e a r . However, i t recognizes there may be a case that i f such an arrangement i s other than the cost sharing arrangement, and the R & D f a c i l i t y i s treated as a p r o f i t center, the corporation which undertook R & D a c t i v i t i e s could charge the amount based on a reasonable arm's length p r i c e which does not exceed Canadian taxpayer's f a i r 59 share of such R & D expense, marked up at a reasonable rate. Bona f i d e cost sharing arrangements IC 87-2 states, "payments for the use of R & D usually a t t r a c t withholding t a x . " 6 0 However, i f a payment i s made under a "bona f i d e cost sharing arrangement" which provided i n subparagraph 212(1)(d)(viii) of the Income Tax Act, such a payment w i l l not be subject to Part XIII tax. Further, paragraph 30 of Interpretation Bulletin-3 03 ("IT-3 03") provides that for a bona f i d e cost sharing arrangement to e x i s t , the following conditions have to be met: 89 (a) i n addition to sharing research and development costs, any benefits or income r e s u l t i n g from that research and development must also be shared; (b) such costs and revenues must be shown to have been shared on a reasonable basis (the Department does not necessarily regard sales, production or p r o f i t s as e s t a b l i s h i n g a reasonable basis for sharing costs); (c) while only a portion of the cost may be charged to the Canadian resident, he must receive an i n t e r e s t i n a l l property or other things of value r e s u l t i n g from the arrangement; (d) the Canadian resident should have t i t l e or f u l l access to, or a r e a l and genuine i n t e r e s t (and i n the case of non-arm 1s-length transactions generally an unr e s t r i c t e d interest) i n , a l l property or things of value generated by the research and development, including patents and know-how, except that: (i) where the non-resident does not permit the Canadian resident to have t i t l e to a patent, design, etc., the l a t t e r should have unrestricted use of i t at no a d d i t i o n a l cost; and ( i i ) geographical r e s t r i c t i o n s would be permissible so long as the Canadian resident were e n t i t l e d to use the property i n question anywhere i n Canada where he has a manufacturing or sales operation; (e) double charges should not a r i s e through charging a taxpayer for a portion of the research and development costs and also a royalty for the subsequent use of the property. I t may involve a l o t of d i f f i c u l t i e s to s a t i s f y the above-mentioned conditions. But, i t i s tempting f o r a MNC whose parent company i s situated i n the U.S. to disguise royalty payments as contribution under a cost sharing arrangement. Since, whereas a royalty payment i s subject to the withholding tax under the Canada-U.S. Income Tax Convention, 6 1a payment under a "bona f i d e cost sharing arrangement" i s not subject to the withholding tax. I t should be noted that, as paragraph 39 of IC 90 87-2 states, " i f a p r o f i t element i s present, the t o t a l amount of the payments under the arrangement w i l l a t t r a c t Part XIII tax." On the other hand, the OECD Report states that since payments under cost contribution arrangements are 11 ingredients i n the c a l c u l a t i o n of business p r o f i t s and d i f f e r i n character from 62 r o y a l t i e s " , such payments, even i f the p r o f i t element i s 63 included, should not be subject to withholding tax. Documentation of arrangement In each cost contribution arrangement, as stated i n IT-303, Revenue Canada would t e s t the propriety of the cost sharing basis by examining the value or pot e n t i a l value of the arrangement to the partic i p a n t s and by ascertaining whether i t s share of the t o t a l cost was i n l i n e with the s i z e and nature of i t s operations and whether i t i s l i k e l y to benefit from the arrangement i n the l i g h t of the r e l a t i o n s h i p of i t s size , operations and contribution to the si z e , operations and contribution of a l l the contributors taken together. 64 Therefore, as the OECD Report suggests, a MNC or pa r t i c i p a n t should define p r e c i s e l y the terms and conditions of the cost contribution arrangements i n a written contract concluded i n advance, and be able to demonstrate that the R & D i s i n conformity with the written agreement and has been or w i l l be 65 c a r r i e d out i n practi c e . Revenue Canada also requests the taxpayer to provide a l l the evidence, including the data concerning other e n t i t i e s i n a group, which i s necessary to es t a b l i s h that such a arrangement i s a bona f i d e cost sharing arrangement. 91 I t seems that the heavy burden i s imposed on the taxpayers, however, considering the p o s s i b i l i t y f o r tax avoidance through cost contribution arrangements, Revenue Canada's approach might be reasonable. There i s some c r i t i c i s m that despite i t s hard "facts and circumstances" t e s t , the IRS i s more generous i n t h i s area than Revenue Canada. However, as stated before, most parent companies of large Canadian companies are situated i n the U.S., and most of the R & D a c t i v i t i e s are undertaken i n the U.S., therefore, when the IRS deals with cost contribution arrangements, t h e i r main concern i s the amount of contribution received by the U.S. companies from t h e i r foreign s u b s i d i a r i e s . On the contrary, for Revenue Canada, most of the cost contribution cases are concerning the d e d u c t i b i l i t y of payments under the arrangements made by the Canadian taxpayers. I t might be in e v i t a b l e that while Revenue Canada i s cautious about double deducting of costs, the IRS may not pay attention to double charging by the U.S. parent companies to t h e i r foreign s u b s i d i a r i e s . 92 SUBCHAPTER IV - FOOTNOTES 1 Transfer P r i c i n g and Multinational Enterprises, Report of the OECD Committee on F i s c a l A f f a i r s (1979), at para. 79 2 Ibid, para. 81 3 Ibid, para. 82 4 Ibid, para. 83 5 Revenue Canada, International Transfer P r i c i n g and Other International Transactions, Information C i r c u l a r 87-2 (1987), at para. 42 6 Ibid, para. 43 7 Porta-Svstem Limited v. Her Majesty The Queen, (1980) D.T.C. 6046 8 Supra, note 5, at para. 13 9 Supra, note 1, at para. 85 10 Model Double Taxation Convention on Income and on Cap i t a l . Report of the OECD Committee on F i s c a l A f f a i r s (1977) , at para. 12 of the Commentary on A r t i c l e 12 11 Supra, note 1, at para. 85 12 Supra. note 1, at para. 89 13 Supra. note 1, at para. 90 14 Supra. note 1, at para. 91 15 Supra, note 1, at para. 92 16 Supra. note 1, at para. 92 17 Supra. note 1, at para. 94 18 Supra. note 1, at para. 94 19 Supra. note 5, at para. 45 20 Supra, note 1, at para. 94 21 Supra, note 1, at para. 94 93 22 Supra, note 1, at para. 95 23 Supra, note 1, at para. 95 24 Supra. note 1, at para. 96 25 Supra. note 1, at para. 95 26 Supra, note 1, at para. 96 27 Supra r note 1, at para. 96 28 Supra, note 1, at para. 98 29 Supra. note 1, at para. 99 30 Supra. note 1, at para. 99 31 Supra r note 1, at para. 100 32 Supra. note 1, at para. 100 33 Supra. note 1, at para. 100 34 Supra, note 1, at para. 98 and 100 35 Supra. note 1, at para. 93 36 Supra. note 1, at para. 103 37 Supra. note 1, at para. 103 38 Supra. note 1, at para. 103 39 Supra. note 1, at para. 104 40 Supra, note 1, at para. 109 41 The U.S. IRC Regulation 1.482-2(d)(4) 42 Supra. note 5, at para. 35 43 Supra, note 1, at para. 112 44 Supra, note 1, at para. 105 45 Supra, note 1, at para. 105 46 Supra, note 1, at para. 105 47 Supra, note 1, at para. 116 94 48 Supra. note 1, at para. 121 49 Supra, note 1, at para. 121 50 Supra. note 1, at para. 121 51 Supra, note 5, at para. 37 52 Supra. note 1, at para. 112 53 Supra. note 1, at para. 114 54 Supra. note 1, at para. 114 55 Supra, note 5, at para. 38 56 Supra. note 5, at para. 38 57 Supra. note 1, at para. 119 58 Supra, note 1, at para. 120 59 Supra. note 5, at para. 38 60 Supra. note 5, at para. 39 61 A r t i c l e XII of the Canada- U.S. Income Tax Convention 62 Supra, note 1, at para. 123 63 Supra. note 1, at para. 123 64 Revenue Canada, Income Tax Act: Know-How and Similar Payments to Non-Residents, Interpretation Bulletin-303 (1976), at para. 31 65 Supra, note 1, at para. 113 95 SUBCHAPTER V CORRESPONDING ADJUSTMENT AND MUTUAL AGREEMENT PROCEDURE 1. INTRODUCTION Where the transfer p r i c e i n an intra-group transaction between the Canadian taxpayer and i t s foreign related company i s not accepted as a reasonable arm's length p r i c e by Revenue Canada and an adjustment i s made, unless the tax authority i n the country where the related company i s situated does not make an adjustment to correspond to the primary adjustment by Revenue Canada, the MNC to which the Canadian taxpayer belongs w i l l s u f f e r double taxation. Since the foreign tax c r e d i t system w i l l not r e l i e v e taxpayers from economic double taxation and taxpayers also cannot expect much help from other domestic provisions or tax a u t h o r i t i e s ' d i s c r e t i o n , r e l i e f from double taxation would considerably depend on the mutual agreement procedure between the relevant competent a u t h o r i t i e s . In Canada, the l e g a l authority f o r the corresponding adjustment and mutual agreement procedure administered by Revenue Canada i s based on various b i l a t e r a l tax conventions which Canada concluded and the s p e c i f i c procedures to be taken by Revenue Canada and Canadian taxpayers are provided i n Information C i r c u l a r 71-17R2 ("IC 71-17R2"). Since Canada has adopted the OECD Model Double Taxation 96 Convention ("OECD Convention") and most of "modern" b i l a t e r a l conventions which Canada concluded are modeled on the OECD Convention, i t would be appropriate and necessary (except where expressly otherwise provided by a p a r t i c u l a r b i l a t e r a l convention, or the Income Tax Act or IC 71-17R2) to interpret and enforce the Canadian corresponding adjustment and mutual agreement procedure system with reference to the OECD Convention and i t s commentary ("OECD Commentary") and the OECD 1984 Report ( i . e . , OECD Report "Transfer P r i c i n g and Multinational Enterprises: Three Taxation Issues"(1984)). I t would be also appropriate when discussing the present system to put emphasis on the Canada-U.S. Income Tax Convention ("Canada-U.S. Convention") for the reason that t h i s convention i s not only an example of a t y p i c a l "modern" tax convention modeled on the OECD Convention but also contains several provisions aimed at solving the problems experienced by competent aut h o r i t i e s of both countries. 2. CORRESPONDING ADJUSTMENT OECD Convention A r t i c l e 9 of the OECD Convention provides that: 1. Where a) an enterprise of a Contracting State p a r t i c i p a t e s d i r e c t l y or i n d i r e c t l y i n the management, control or c a p i t a l of an enterprise of the other Contracting State, or b) the same persons p a r t i c i p a t e d i r e c t l y or i n d i r e c t l y i n the management, control or c a p i t a l of an enterprise of a Contracting State and an 97 enterprise of the other Contracting State, and i n ei t h e r case conditions are made or imposed between the two enterprises i n t h e i r commercial or f i n a n c i a l r e l a t i o n s which d i f f e r from those which would be made between independent enterprises, then any p r o f i t s 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 i n the p r o f i t s of that enterprise and taxed accordingly. 2. Where a Contracting State includes i n the p r o f i t s of an enterprise of that State -and taxes accordingly-p r o f i t s on which an enterprise of the other Contracting State has been charged to tax i n that other State and the p r o f i t s so included are p r o f i t s which would have accrued to the enterprise of the first-mentioned State i f the conditions made between the two enterprises had been those which would have been made between independent enterprises, then that other State s h a l l make an appropriate adjustment to the amount of the tax charged therein on those p r o f i t s . In determining such adjustment, due regard s h a l l be had to the other provisions of t h i s Convention and the competent au t h o r i t i e s of the Contracting States s h a l l i f necessary consult each other. Paragraph 1 states the "arm's length p r i n c i p l e " and only confirms e x i s t i n g p r i n c i p l e s of the contracting states, e.g., section 69 of the Canadian Income Tax Act. Paragraph 2 provides fo r a "corresponding adjustment"; that i s , according to the OECD Commentary, where the corporation of State A whose p r o f i t s are adjusted upwards i s l i a b l e for tax on an amount of p r o f i t which has already been taxed i n the hands of i t s associated corporation i n State B, State B s h a l l make an appropriate adjustment so as to r e l i e v e the double t a x a t i o n . 1 Problem As the OECD 1984 Report states, i n theory the adjustment to the arm's length p r i c e under paragraph 9(1) should create no 98 problems i n a r r i v i n g at the amount of r e l i e f due under paragraph 2 9(2) and MNCs should be re l i e v e d from double taxation eventually. However, i n practice there are a number of d i f f i c u l t i e s . In the above-mentioned case, a corresponding adjustment i s not automatically made by State B simply because the p r o f i t s i n State A have been increased. The OECD 1984 Report states: a corresponding adjustment i s mandatory only i f , and to the extent, that the relevant tax au t h o r i t i e s agree with the adjustment of the pri c e made by the tax authority i n the f i r s t State. 3 The r e l i e f a v a i l a b l e under paragraph 9(2) may not be forthcoming i f the two tax auth o r i t i e s have d i f f e r e n t views on what i s the appropriate arm's length p r i c e for a p a r t i c u l a r transaction. MNCs have been complaining about t h i s deficiency i n the present system and have urged fo r imposing an ob l i g a t i o n on State 4 B to comform to the primary adjustment by State A. But, as the OECD 1984 Report indicates: Imposing a simple mandatory requirement on tax aut h o r i t i e s to conform automatically to a tran s f e r p r i c i n g adjustment made by the tax au t h o r i t i e s of another country, would not protect MNEs against a r b i t r a r y or capricious adjustments,...providing i n t h i s way that tax aut h o r i t i e s must conform to the action of other tax aut h o r i t i e s over whom they have no control would leave the conforming tax aut h o r i t i e s themselves no protection against any a r b i t r a r y or capricious adjustments... 5 In other words, the tax authorities who made the adjustment i n the f i r s t place would be able to make a r b i t r a r y adjustments to the extent allowed under t h e i r domestic law and there would be strong incentives f or tax authorities to make transfer p r i c i n g 99 adjustments. Therefore, such an approach should not be adopted i n order to protect the inte r e s t s of not only the tax authorities but also of the MNCs. In most transfer p r i c i n g adjustment cases, the corresponding adjustment could be made through mutual agreement procedures. Canada-U.S. Income Tax Convention Paragraph 9(3) of Canada-U.S. Convention provides for a corresponding adjustment: 3. Where an adjustment i s made or to be made by a Contracting State i n accordance with paragraph 1, the other Contracting State s h a l l (notwithstanding any time or procedural l i m i t a t i o n s i n the domestic law of that other State) make a corresponding adjustment to the income, loss or tax of the related person i n that other State i f : (a) I t agrees with the first-mentioned adjustment; and (b) Within s i x years from the end of the taxable year to which the f i r s t mentioned adjustment r e l a t e s , the competent authority of the other State has been n o t i f i e d of the first-mentioned adjustment. As set out i n the OECD Convention, a corresponding adjustment s h a l l be made i f the other State agrees with the primary adjustment. Even though the p r i c i n g methods u t i l i z e d by Revenue Canada and the IRS are si m i l a r , there would s t i l l be a l o t of d i f f i c u l t i e s i n reaching an agreement on the adjustment made by other tax authority regarding p r i n c i p l e s and the amount. Thus, actual r e l i e f from double taxation would depend on the mutual agreement procedures between the competent a u t h o r i t i e s . As mentioned before, an automatic corresponding adjustment system should not be acceptable to both tax a u t h o r i t i e s . (The "six 100 years" r u l e i n subparagraph (b) w i l l be dealt la t e r . ) I t should be noted that some of the "old" type tax conventions which Canada concluded do not have a provision equivalent to paragraph 9(2) of the OECD Convention. For example, the Canada-Japan Income Tax Convention does not have a provision f o r corresponding adjustments whereas A r t i c l e 4 of the Convention provides the "arm's length p r i n c i p l e " . 3 . MUTUAL AGREEMENT PROCEDURE OECD Convention A r t i c l e 25 of the OECD Convention provides for a "mutual agreement procedure": 1. Where a person considers that the actions of one or both of the Contracting States r e s u l t or w i l l r e s u l t f o r him i n taxation not i n accordance with the provisions of t h i s Convention, he may, ir r e s p e c t i v e of the remedies provided by the domestic law of those States, present h i s case to the competent authority of the Contracting State of which he i s a resident or, i f his case comes under paragraph 1 of A r t i c l e 24, to that of the Contracting State of which he i s a national. The case must be presented within three yaers from the f i r s t n o t i f i c a t i o n of the action r e s u l t i n g i n taxation not i n accordance with the provisions of the Convention. 2. The competent authority s h a l l endeavour, i f the objection appears to i t to be j u s t i f i e d and i f i t i s not i t s e l f able to a r r i v e at a s a t i s f a c t o r y solution, to resolve the case by mutual agreement with the competent authority of the other Contracting State, with a view to the avoidance of taxation which i s not i n accordance with the Convention. Any agreement reached s h a l l be implemented notwithstanding any time l i m i t s i n the domestic law of the Contracting States. 101 3. The competent authorities of the Contracting States s h a l l endeavour to resolve by mutual agreement any d i f f i c u l t i e s or doubts a r i s i n g as to the in t e r p r e t a t i o n or a p p l i c a t i o n of the Convention. They may also consult together for the elimination of the double taxation i n cases not provided for i n the Convention. 4. The competent au t h o r i t i e s of the Contracting State may communicate with each other d i r e c t l y f o r the purpose of reaching an agreement i n the sense of the preceeding paragraphs. When i t seems advisable i n order to reach agreement to have an or a l exchange of opinions, such exchange may take place through a Commission consisting of representatives of the competent au t h o r i t i e s of the Contracting States. A r t i c l e 25 provides three d i f f e r e n t types of mutual agreement procedures. The f i r s t i s dealt with i n paragraphs 1 and 2 and applies to "taxation not i n accordance with the provisions of the Convention" and the taxpayer himself i n i t i a t e s t h i s procedure. The other two are dealt with i n paragraph 3: one i s f o r resolving " d i f f i c u l t i e s and doubts a r i s i n g as to the int e r p r e t a t i o n or app l i c a t i o n of the Convention" and the other i s for "elimination of double taxation i n cases not provided for i n the Convention." 6 Actual mutual agreement procedures concerning transfer 7 p r i c i n g adjustments are those of the f i r s t type. However, where a p a r t i c u l a r b i l a t e r a l tax convention does not have the provision on the l i n e of paragraph 9(2) of the OECD Convention, according to a l i t e r a l i n t e r p r e t a t i o n , as the OECD 1984 Report indicates, no provision i n the convention imposes a requirement on the State which has included i n i t s tax base p r o f i t s unduly transferred to a company which i s a resident of that State to revise i t s assessment i n order to exclude such excess p r o f i t s ; taxation of such p r o f i t s i s therefore not contrary to the convention and paragraphs 1 and 2 of A r t i c l e 25 do not apply.8 102 In such a case, the taxpayer i n question could be relieved from economic double taxation by domestic law or through the 9 exercise of discretionary power by the tax authority, and some countries eliminate double taxation by u t i l i z i n g the provisions of b i l a t e r a l tax conventions equivalent to paragraph 3 of A r t i c l e 25 of the OECD Convention. 1 0 In order to avoid any doubt i n the above-mentioned cases (where the convention does not contain the provisions s i m i l a r to those of paragraph 2 of A r t i c l e 9 of the OECD Convention), the OECD 1984 Report recommends to interpret A r t i c l e 9 and 25 of the OECD Convention as follows: the mere fac t that contracting p a r t i e s inserted i n the convention the text of A r t i c l e 9, as l i m i t e d to the text of paragraph 1 ... indicates that the intention was to have economic double taxation covered by the convention. As a r e s u l t , . . . economic double taxation r e s u l t i n g from adjustments made to p r o f i t s by reasons of t r a n s f e r p r i c i n g i s not i n accordance with - at le a s t - the s p i r i t of the convention and f a l l s within the scope of the mutual agreement procedure set up under A r t i c l e 25. 11 Problems Although, as the OECD Report states, the mutual agreement procedure has been recognized as an e f f i c i e n t and f l e x i b l e instrument i n the interpretation, a p p l i c a t i o n and development of double taxation agreements and a suitable means for the elimination of both j u r i d i c a l and economic double taxation, a 12 number of problems have been complained by MNCs. F i r s t , i n t h i s procedure the competent a u t h o r i t i e s have only a duty to negotiate and they are not required to reach an 103 13 agreement. Accordingly there w i l l be cases where a corresponding adjustment w i l l not be made even though the competent authorities discussed the issue using the mutual agreement procedure. Second, where the competent a u t h o r i t i e s do reach an agreement, the agreement might not be implemented due to 14 c o n f l i c t i n g domestic law such as statutory time l i m i t s . For example, i f a tax authority i n one country made an adjustment on the t r a n s f e r p r i c e of the MNC a f t e r the tax authority i n the other country where the related company i s situated has already f i n a l i z e d the computation of that company's taxable p r o f i t s and the statutory time l i m i t had run out, i t i s l e g a l l y unable to make the corresponding adjustment and unrelievable double 15 taxation would remain. Although paragraph 3 of A r t i c l e 25 of the OECD Convention c l e a r l y provides, "any agreement reached s h a l l be implemented notwithstanding any time l i m i t s i n the domestic law of the Contracting States", according to the OECD Commentary, This provision does not prevent... such States as are not, on c o n s t i t u t i o n a l or other l e g a l grounds, able to overrule the time l i m i t s i n the domestic law, from i n s e r t i n g i n the mutual agreement i t s e l f such time l i m i t s as are adapted to t h e i r i n t e r n a l statute of l i m i t a t i o n . 16 Note that several countries including Canada have made reservations that the implementation of r e l i e f s and refunds following a mutual agreement ought to remain linked to time l i m i t s prescribed by t h e i r domestic laws.17 Third, according to MNCs' experiences, the operation of the 104 mutual agreement procedure has been time-consuming and uncertain 18 i n i t s r e s u l t s . Fourth, MNCs also oppose the tax au t h o r i t i e s ' propensity to use the "broad brush" approach. That i s , tax auth o r i t i e s tend to lump a l l current cases together to negotiate a general settlement 19 on a very rough and ready basis. F i f t h , MNCs complain that they lack the r i g h t to p a r t i c i p a t e 20 i n the procedure other than to i n i t i a t e the procedure. Mandatory corresponding adjustment system (Compulsory a r b i t r a t i o n process) To eliminate the above-mentioned problems, MNCs have urged imposing the obl i g a t i o n to reach an agreement on the competent a u t h o r i t i e s . In the view of the MNCs, i f competent authorities do not reach an agreement within a ce r t a i n period, they should be required to submit the case to supra-national a r b i t r a t o r s and 21 abide by t h e i r decision. As the MNCs point out, the compulsory a r b i t r a t i o n procedure would provide MNCs with complete r e l i e f from double taxation as well as the cert a i n t y of a decision and the reduction of delay. In addition, MNCs would be allowed the ri g h t to present evidence and argue i n the process and obviate the danger of a "broad 22 brush" approach by the competent a u t h o r i t i e s . Furthermore, the p o s s i b i l i t y of a r b i t r a t i o n would l i k e l y prompt the competent au t h o r i t i e s to speed up the process and reach an agreement 23 quickly i n more cases. On the other hand, a number of possible problems may ar i s e . 105 For example, to ensure ce r t a i n t y and the speed of the a r b i t r a t i o n , i t might be necessary to f i n a l i z e the decision of 24 a r b i t r a t i o n . Accordingly, i t would be inappropriate to allow the taxpayer to l i t i g a t e i n the domestic courts as well as submit to 25 the compulsory a r b i t r a t i o n procedure. I t might be necessary to require the taxpayer, before invoking the a r b i t r a t i o n procedure, 26 to exhaust or abandon h i s domestic r i g h t of appeal. I t might also be necessary to disallow appeals against the decision of 27 a r b i t r a t i o n . However, MNCs may want to maintain the f l e x i b i l i t y to choose whichever decision i s advantageous to them. I t might also be necessary to make a r b i t r a t o r s subject to some pos s i -b i l i t y of a check on t h e i r a c t i v i t i e s to protect the tax 28 au t h o r i t i e s and taxpayers from a r b i t r a r y decisions. Or, i f the approach taken by a r b i t r a t o r s i s to look for a simple compromise, i . e . , to seek middle ground between the d i f f e r e n t views presented rather than an approach equivalent to l i t i g a t i o n , the approach would produce a pragmatic r e s u l t more quickly and le s s expensively. I t would, however, hinder the competent a u t h o r i t i e s from conceding points to each other when negotiating a solu t i o n at an e a r l i e r stage i n order to obtain a 29 more advantageous decision i n the l a t e r a r b i t r a t i o n . Above a l l , t h i s compulsory a r b i t r a t i o n procedure i s an unprecedented surrender of f i s c a l sovereignty for tax authorities 30 and i s not l i k e l y to be acceptable. Furthermore, i n the case where the MNC manipulated the tr a n s f e r p r i c e f o r the purpose of avoiding or evading tax, i t would be overgenerous to provide such a taxpayer with complete 106 r e l i e f from double taxation. A f t e r considering the various aspects discussed above, the OECD 1984 Report d i d not endorse t h i s compulsory a r b i t r a t i o n 31 procedure. I t should be noted that the OECD Commentary suggests two possible approaches: One i s to ask the OECD Committee on F i s c a l A f f a i r s to give an opinion on the correct understanding of the provision of the OECD Convention, and the other i s to ask the opinion of c e r t a i n persons chosen among the competent authorities 32 of the OECD member countries. But, as the OECD 1984 Report states, while they remain a p o t e n t i a l l y valuable means of resolving differences between tax aut h o r i t i e s , there i s no basis i n experience for estimating how fa r they may be useful for t h i s 33 purpose. To sum up the OECD's perspective on the present mutual agreement procedure: despite the several problems considered above, the mutual agreement procedure can be a very useful instrument i n resolving d i f f i c u l t i e s a r i s i n g out of i n the 34 tra n s f e r p r i c i n g cases. Up to the present time, very few trans f e r p r i c i n g adjustments cases have led to adjustments which give r i s e to unresolvable disputes between the relevant tax aut h o r i t i e s or leave the taxpayers s u f f e r i n g s i g n i f i c a n t and 35 inequitable double taxation. Acceptable compromises have i n 3 6 prac t i c e nearly always been found. Most of the d i f f i c u l t i e s can be eliminated to some extent by increased e f f o r t s by competent au t h o r i t i e s and taxpayers. Therefore, any changes to the OECD 37 Convention would be unnecessary. 107 As to possible future improvements, the OECD 1984 Report made the following suggestions. Time l i m i t The best way to eliminate the d i f f i c u l t i e s caused by the time l i m i t i s to ensure that the agreement reached by the mutual 38 agreement procedure overrides domestic time l i m i t s . However, as 39 stated before, some countries are unable to guarantee t h i s . In such cases, i n order to minimize the obstacles caused by the time l i m i t , tax aut h o r i t i e s should consider making the transfer 40 p r i c i n g adjustments as early as possible and i f i t i s l i k e l y that an adjustment w i l l be made, tax au t h o r i t i e s should n o t i f y 41 the taxpayer of i t s intention and be prepared to enter into discussion pursuant to the mutual agreement procedure at as the e a r l i e s t stage possible i n view of t h e i r administrative 42 constraints. I f necessary, the tax aut h o r i t i e s should suspend the time l i m i t . I t might also be appropriate to introduce a provision into the b i l a t e r a l tax convention which would p r o h i b i t the making of a transfer p r i c i n g adjustment a f t e r the expiry of an agreed p e r i o d . 4 3 Time-consuming operation Since the mutual agreement procedure usually involves complex matters which take a long time to unravel and the taxpayer who i s involved with the procedure does not always provide the necessary information timely, the delay i n operation 44 of the procedure i s to some extent i n e v i t a b l e . However, tax 108 a u t h o r i t i e s should make every e f f o r t to avoid delay and to improve t h e i r p ractice insofar as t h e i r administrative resources 45 permit. The OECD 1984 Report suggests several possible ways. I t would help to speed up the procedure by f a c i l i t a t i n g communi-cations between competent au t h o r i t i e s through face to face or 46 telephone discussions. The exchange of information for the purpose of preventing tax avoidance and evasion would be useful i n improving the cooperation between tax a u t h o r i t i e s . An increased willingness on the part of the tax a u t h o r i t i e s to resolve t r a n s f e r p r i c i n g problems and the adoption of a f l e x i b l e approach to f i n d compromise would remove much of the presently 47 encountered delay and d i f f i c u l t i e s . Simultaneous examination would be useful not only to allow for e f f e c t i v e and economical audits against i n t e r n a t i o n a l tax avoidance or evasion but also to help solve the problems caused by delay i n procedure or c o n f l i c t i n g time l i m i t s . 4 8 The delegation of the discussion to o f f i c i a l s at a lower l e v e l , usually the case o f f i c e r i n the f i e l d , and supervisory control by the central competent authority would speed up the procedure, while also ensuring consistent 49 decisions. Taxpayers' p a r t i c i p a t i o n Since the mutual agreement procedure i s not a process of l i t i g a t i o n but rather a process of discussion between the competent a u t h o r i t i e s , competent au t h o r i t i e s are not necessarily required to give the taxpayer who invoked the procedure the right 109 50 to present evidence and argue i n the proceedings. However, i n pra c t i c e , the taxpayer i s normally kept informed of the progress of discussions and i s often asked during the course of the 51 discussion whether he can accept the settlement envisaged. In some cases, the taxpayer may be given opportunities to present 52 relevant facts and arguments to the competent a u t h o r i t i e s . I t i s recommended that such practices be adopted as widely as p o s s i b l e . 5 3 P u b l i c a t i o n of information concerning procedure I t i s desirable not only for the taxpayers' convenience but also for tax a u t h o r i t i e s ' convenience to inform the taxpayers of 54 the procedure to be taken. As stated before, Revenue Canada has issued Information C i r c u l a r 71-17R2 and the IRS has done likewise by issuing Revenue Procedure 70-18. In addition, i t has been suggested that a s p e c i f i c taxpayer's case be published. Such publ i c a t i o n might be useful, but the necessity of protecting the c o n f i d e n t i a l i t y of the 55 taxpayer's a f f a i r s should be f u l l y taken into account. C o n f l i c t i n g court decisions Whether or not the agreement reached by mutual agreement procedure overrides the c o n f l i c t i n g decision i n a domestic court would present d i f f i c u l t problems. The resolution of t h i s problem depends on the domestic l e g i s l a t i o n of each country, and most countries do not accept such overriding. 5 6Some countries require the taxpayer, before invoking the mutual agreement procedure, to 110 57 exhaust or abandon a l l domestic remedies. However, as the OECD Commentary states, mutual agreement procedures should be avai l a b l e to taxpayers "without depriving them of the ordinary 58 l e g a l remedies a v a i l a b l e . " E s p e c i a l l y when the agreement i s not acceptable f o r the taxpayer, the taxpayer should be e n t i t l e d to appeal to a domestic court. Therefore, one possible way to eliminate t h i s problem i s that the taxpayer should quickly a l e r t h i s r e l a t e d company or the MNC1s headquarter i n the other country the p o s s i b i l i t y that a court decision may a f f e c t a poten t i a l t r a n s f e r p r i c i n g issue so that they can invoke the procedure at t h e i r end. The tax authorities should also a l e r t the relevant treaty partners 1 tax aut h o r i t i e s i f there i s a s i g n i f i c a n t chance that a court decision w i l l provoke a request f o r a mutual agreement procedure as a consequence. 5 9 MNCs e f f o r t p r i o r t o the formal mutual agreement procedure I t might be a less expensive and less time-consuming for the MNC, when faced with a transfer p r i c i n g adjustment i n one country, to t r y to make appropriate arrangements with or seek to s e t t l e the case through negotiations with the tax au t h o r i t i e s i n the other country which would have to make the corresponding adjustment by i t s own e f f o r t before a formal mutual agreement procedure i s i n i t i a t e d . 6 0 Another important consideration to be given i s to make every e f f o r t to s e t t l e the case before an irrevocable decision i s made i n the adjusting c o u n t r y 6 1 and to keep to a minimum the fo r m a l i t i e s involved i n the operations of the mutual agreement I l l p rocedure. Canada-U.S. Income Tax Convention A r t i c l e XXVI of Canada-U.S. Convention p r o v i d e s f o r the mutual agreement procedure. I t s b a s i c p r i n c i p l e i s same as t h a t o f the OECD Convention. A c c o r d i n g l y , the competent a u t h o r i t i e s have o n l y a duty t o n e g o t i a t e and are not r e q u i r e d t o reach an agreement. However, t h e r e a re s e v e r a l p o i n t s which can be regarded as improvements f o r t he purpose o f r e l i e v i n g taxpayers from double t a x a t i o n . F i r s t , t he agreement reached by the mutual agreement procedure can o v e r r i d e domestic time l i m i t s o r p r o c e d u r a l l i m i t a t i o n s . Paragraph 2 of A r t i c l e XXVI s t a t e s t h a t any agreement reached s h a l l be implemented n o t w i t h -s t a n d i n g any time o r o t h e r p r o c e d u r a l l i m i t a t i o n s i n the domestic law of the C o n t r a c t i n g S t a t e s . Although t h i s p r o v i s i o n does not apply t o the mutual agreement procedure f o r t r a n s f e r p r i c i n g adjustments under A r t i c l e IX, paragraph 3 o f A r t i c l e IX a l s o p r o v i d e s i n a s i m i l a r way, the o t h e r C o n t r a c t i n g S t a t e s h a l l ( n o t w i t h s t a n d i n g any time o r p r o c e d u r a l l i m i t a t i o n i n the domestic law of t h a t o t h e r State) make a correspondong adjustment. C o n s i d e r i n g the f a c t t h a t Canada made a r e s e r v a t i o n on the o v e r r i d i n g p r o v i s i o n i n paragraph 2 o f A r t i c l e 25 of the OECD 63 Convention, the i n t r o d u c t i o n of the above-mentioned p r o v i s i o n s t o the Canada-U.S. Convention i s a c o n s i d e r a b l e improvement. Second, the above-mentioned o v e r r i d i n g p r o v i s i o n s o n l y apply 112 the competent authority of the other Contracting State has received n o t i f i c a t i o n that such a case e x i s t s within s i x years from the end of the taxable year to which the case relates.64 A r t i c l e IX also states i n a s i m i l a r way that a corresponding adjustment w i l l be made i f the other State agrees with the f i r s t -mentioned adjustment and i f within s i x years from the end of taxable year to which the first-mentioned adjustment re l a t e s , the competent authority of the other State has been n o t i f i e d of the first-mentioned adjustment. 65 As the OECD 1984 Report states, there must be obviously some l i m i t to the period during which claims to r e l i e f may be made and the tax l i a b i l i t y must become f i n a l at some stage or there would be no ce r t a i n t y f or the tax auth o r i t i e s or indeed for taxpayers. 6 6 Therefore, t h i s " s i x years" r u l e should be a reasonable l i m i t a t i o n . Interestingly, since the Canadian Income Tax Act sets most of the time l i m i t s for assessment, reassessment and refund to be s i x years, i t can be said that Canada has not su b s t a n t i a l l y changed i t s p o s i t i o n on the overriding provisions. Third, i t should be noted that A r t i c l e IX grants an u n i l a t e r a l r e l i e f . According to the Technical Explanation of the Canada-U.S. Convention ("Technical Explanation"), Paragraph 4 provides that i n a case where the other Contracting State has not been n o t i f i e d as provided i n paragraph 3 [ i . e . , within s i x years] and i f the person whose income, loss or tax i s being adjusted has not received n o t i f i c a t i o n of that adjustment within f i v e and one-half years from the end of i t s taxation year to 113 which the adjustment r e l a t e s , such an adjustment s h a l l not be made to the extent that the adjustment would give r i s e to double taxation between the United States and Canada. 6 8 This provision i n fact p r o h i b i t s tax au t h o r i t i e s from making tr a n s f e r p r i c i n g adjustments a f t e r f i v e and one-half years from the end of taxation year and would be useful for minimizing the l i k e l i h o o d of unrelievable double t a x a t i o n . 6 9 Fourth, the corresponding adjustment and mutual agreement procedures f o r the transfer p r i c i n g adjustment do not apply i n the case of fraud, w i l l f u l default or neglect, or gross 70 negligence. As stated before, since i t would be overgenerous to provide complete r e l i e f from double taxation to those who manipulate the tran s f e r prices i n order to avoid or evade tax, t h i s l i m i t a t i o n seems reasonable. In addition, A r t i c l e XXVI provides f o r the same three types of mutual agreement procedures as the OECD Convention. Para-graph 3 s p e c i f i e s a l i s t of subjects or po t e n t i a l subjects, but the l i s t i s not exhaustive. According to the Technical Explana-t i o n , competent aut h o r i t i e s can determine the tax l i a b i l i t y of a s p e c i f i c person or es t a b l i s h rules, guidelines and procedures that w i l l apply generally under the Convention i n order to 71 resolve issues f o r classes of taxpayers. As to the re a l t i o n s h i p with domestic l i t i g a t i o n procedures, paragraph 1 of A r t i c l e XXVI provides that the taxpayer may request the mutual agreemnet procedure " i r r e s p e c t i v e of the remedies provided by the domestic law". According to the Technical Explanation, to request mutual 114 agreement procedures for transfer p r i c i n g adjustments, 72 an adjustment which " i s made or to be made" does not require a Contracting State to formally propose an adjustment before paragraph 3 becomes pertinent. 73 74 This i n t e r p r e t a t i o n follows the OECD Commentary and would be useful f o r s e t t l i n g a case before irrevocable decisions are made. The Technical Explanation also provides: The n o t i f i c a t i o n required by i n paragraph 3 [of A r t i c l e IX] may be made by any of the related persons involved or by the competent authority of the State which makes or i s to make the i n i t i a l adjustment. 75 The n o t i f i c a t i o n required to be made to the person to whom the i n i t i a l adjustment r e l a t e s i n paragraph 4 of A r t i c l e IX need not be a formal adjustment but must be i n writing and must contain s u f f i c i e n t d e t a i l s to permit the taxpayer to give the n o t i f i c a -76 t i o n to the other State. When comparing the Canada-U.S. Convention with the OECD Convention, i t can be said that the Canada-U.S. Convention i s not only modeled on OECD Convention but also has the provisions which might improve the d e f i c i e n c i e s i n the OECD Convention and may eliminate some of the d i f f i c u l t i e s experienced by the tax aut h o r i t i e s and MNCs. However, i t should be noted that other b i l a t e r a l tax conventions which Canada concluded do not necessarily have the same provisions or p r i n c i p l e s as the Canada-U.S. Convention; for example, an agreement reached by the mutual agreement procedure s t i l l cannot i n p r i n c i p l e override domestic l i m i t a t i o n s . 115 77 4. SPECIFIC PROCEDURES TO BE TAKEN BY REVENUE CANADA AND  CANADIAN TAXPAYERS IN THE MUTUAL AGREEMENT PROCEDURE Information C i r c u l a r 71-17R2 As stated before, Revenue Canada set out the procedures to follow when a person requests for the mutual agreement procedure i n Information C i r c u l a r 71-17R2. The p o l i c y of t h i s information c i r c u l a r aims to eliminate the various d i f f i c u l t i e s i n mutual agreement procedures as much as possible. Since, Canada does not i n p r i n c i p l e allow an agreement reached by the mutual agreement procedure to override the domestic time or other procedural l i m i t a t i o n s (except for the Canada-U.S. Convention) and most b i l a t e r a l tax conventions provide for time l i m i t s , IC 71-17R2 t r i e s to minimize obstacles come from time l i m i t s and t r i e s to speed up the operation of the mutual agreement procedure. Scope of mutual agreement procedure As paragraph 3 of IC 71-17R2 c l e a r l y states, not only j u r i d i c a l but also economic double taxation would f a l l within the scope of the mutual agreement procedure by Revenue Canada. Requests f o r competent authority consideration Canadian taxpayers can make a request f o r competent authority consideration, i f : 116 (a) the taxpayer has made a written request f o r an adjustment as a r e s u l t of the action, or proposed action, of a foreign government, which adjustment has been refused, or (b) Revenue Canada, Taxation adjusts, or formally proposes to adjust, the incomes of the taxpayer and t h i s action r e s u l t s , or w i l l r e s u l t , i n double taxation. 78 IC 71-17R2 requires that requests "should be made as soon as the foreign government has formally proposed an adjustment" and the request f o r a corresponding adjustment has been refused by 79 80 Revenue Canada. "An assessment need not have been issued." Taxpayers who make a request for competent authority consideration are required to provide the information s p e c i f i e d i n paragraph 8 of IC 71-17R2. This information i s expected to help Revenue Canada understand the case and process the case speedily. Where a related party of the Canadian taxpayer i n a foreign country i s involved, the taxpayer may i n pra c t i c e be advised that the r e l a t e d party should f i l e a request f o r competent authority 81 consideration i n i t s own country. A c c e p t a b i l i t y of requests Paragraph 10 of IC 71-17R2 s p e c i f i e s the cases i n which a request f o r competent authority consideration w i l l not be accepted. A request w i l l not be accepted for consideration i f : (a) there i s no tax convention with the foreign country involved; 117 (b) i t has not been received within any time l i m i t s s p e c i f i e d i n the p a r t i c u l a r tax convention or the adjustments are i n years which are statute-barred under subsection 152(4) of the Income Tax Act; (c) the issue i s one that the competent a u t h o r i t i e s of each j u r i s d i c t i o n have agreed not to accept (e.g. sub-section 18(4) of the Income Tax Act " t h i n - c a p i t a l i z a -t i o n " cases with the United States); (d) the Canadian taxpayer was unco-operative i n dealings with Revenue Canada personnel during the audit of the double taxation issues or f a i l e d to provide information requested by the Canadian competent authority to help resolve the issue; (e) the taxpayer has f a i l e d to provide the information l i s t e d i n paragraph 3(a), i n which event the taxpayer w i l l be asked to supply the missing information; or (f) the foreign government refuses to deal with the case. Above a l l , subparagraph (b) should be c a r e f u l l y observed by the taxpayer. As paragraph 11 of IC 71-17R2 also states: the Canadian taxpayer i s responsible at a l l times f o r ensuring that the taxation years do not become statute-barred i n Canada or the foreign country i f competent authority discussions become necessary to a l l e v i a t e double taxation. To prevent the taxation years becoming statute-barred, the taxpayer should f i l e s u i t a b l e waivers pursuant to subparagraph 82 152(4)(a)(ii) of the Income Tax Act and make i t s related companies take necessary procedures equivalent to the waiver i n the relevant foreign countries. Where Revenue Canada or the foreign tax authority made an adjustment which gave r i s e to the double taxation a f t e r the taxation year i n the foreign country or i n Canada became statute-83 barred respectively, the taxpayer can expect u n i l a t e r a l r e l i e f . 118 In the case where the foreign tax authority made an adjustment and a corresponding adjustment was requested by the Canadian taxpayer to Revenue Canada a f t e r the relevant taxation years i n Canada became statute-barred, i f the taxpayer can show that the year could not be kept open, Revenue Canada would request the other competent authority to withdraw the adjustment which gave 8 4 r i s e to the double taxation. In the case where Revenue Canada made assessments or proposed to make assessments a f t e r the reassessment period provided by the tax convention or the foreign statute of l i m i t a t i o n s has expired, Revenue Canada may, as a matter of d i s c r e t i o n , revise the Canadian adjustments to the 85 extent necessary to avoid double taxation. Unlike the u n i l a t e r a l r e l i e f provided i n A r t i c l e IX of Canada-U.S. Convention, t h i s r e l i e f i s provided as a matter of d i s c r e t i o n by Revenue Canada or the foreign tax au t h o r i t i e s , and taxpayers should accordingly not expect too much from such r e l i e f . Tax appeals Following the ideas of the OECD Convention and the OECD 1984 Report, Revenue Canada does not require a taxpayer who requests competent authority consideration to exhaust or abandon the appeal procedure i n hi s domestic courts. Revenue Canada c l e a r l y states that, when mutual agreement procedure cannot solve the double taxation problem or the taxpayer r e j e c t s the agreement, the Canadian taxpayer s t i l l has a r i g h t to proceed through the 86 appeal process to the Courts. 119 However, i t should be noted that, as paragraph 15 of IC 71-17R2 states, i f the taxpayer chooses to proceed with the appeal process, while negotiations with the foreign competent au t h o r i t i e s are i n progress, these negotiations w i l l be terminated. Once a decision i s rendered by the Canadian courts, i t cannot be 87 changed, and may not be e f f e c t i v e or persuasive to the foreign competent a u t h o r i t i e s . Revenue Canada therefore has no room for 88 negotiation. IC 71-17R2 states: Any further r e l i e f from double taxation w i l l be possible only i f the foreign competent authority agrees to grant such r e l i e f as a matter of d i s c r e t i o n . 89 Where the mutual agreement procedure i s being proceeded i n p a r a l l e l with the appeal process i n a court, Revenue Canada w i l l make an e f f o r t to minimize the problem by supplying the foreign tax a u t h o r i t i e s with d e t a i l s of, and rati o n a l e for, the outcome 90 of the appeal process. However, Revenue Canada seems to prefer not to be involved with such a s i t u a t i o n . The U.S. Revenue Procedure 70-18 The U.S. IRS provides a guideline explaining the procedure to be followed by the IRS and U.S. taxpayers i n the mutual agreement procedures i n Revenue Procedure 70-18 ("RP 70-18"). The basic p r i n c i p l e of RP 71-18 i s s i m i l a r to that of IC 71-17R2. However, RP 70-18 has several points which would be useful i n minimizing the various d i f f i c u l t i e s with the mutual 120 agreement procedure and f a c i l i t a t i n g the procedure more e f f e c t i v e l y . F i r s t , the U.S. taxpayer i s required to f i l e a request for competent authority consideration not l a t e r than 90 days a f t e r the adjustments by the treaty country are formally proposed and 91 communicated to the related person. Second, the U.S. taxpayer who makes a request i s simul-taneously required to f i l e a claim on Form 843 f o r c r e d i t s or refunds of any overpayment of tax that may be provided by the agreement reached by the IRS and the foreign competent 92 authority. Third, where the p o s i t i o n as to making an adjustment of the tax authority of the treaty country has not been s u f f i c i e n t l y developed to permit competent authority consideration and the statutory period for f i l i n g the above-mentioned claim for c r e d i t or refund i s about to expire, the U.S. taxpayer i n question can f i l e a claim for c r e d i t or refund on Form 843 with information which i s required i f the taxpayer f i l e s a written request for 93 competent authority consideration. The taxpayers must keep the IRS informed as to the proceedings of that treaty country and the adjustment being considered, by f i l i n g semi-annual 94 statements. Fourth, the U.S. taxpayer i s required to include a l l relevant information when submitting h i s written request for competent consideration. Above a l l , i n the case where the IRS made the i n i t i a l adjustment, paragraph 5.07(k) of RP 70-18 requires the taxpayer to provide 121 a statement describing the extent (and amounts of allocation) that the U.S. taxpayer i s w i l l i n g to agree to be bound by any agreement reached by the competent au t h o r i t i e s of the U.S. and the treaty country and st a t i n g that he i s w i l l i n g to enter into a cl o s i n g agreement under section 712 of the Code (and appropriate stipulation) consistent with such condition. Although the statement s h a l l not be considered to be evidence of 95 . the proper amount of the a l l o c a t i o n , i t could be very useful for the IRS when negotiating with the competent authority of the treaty country. F i f t h , section 6 of RP 70-18 requires the U.S. taxpayer to advise h i s related persons to take such timely protective action as may be necessary with foreign taxing a u t h o r i t i e s , including the staying of the expiration of the period of l i m i t a t i o n s on the making of a refund or other tax adjustment, complying with any applicable procedures of the treaty country f o r invoking competent authority consideration, and attempting to r e s i s t an adjustment or obtain an appropriate c o r r e l a t i v e adjustment. Sixth, RP 70-18 also provides u n i l a t e r a l r e l i e f where the modification of the U.S. taxpayer's tax l i a b i l i t y i s prevented by the operation of any law or rul e of law, i . e . the corresponding adjustment cannot be implemented by the time l i m i t , but such u n i l a t e r a l r e l i e f would be made at the d i s c r e t i o n of the 96 competent a u t h o r i t i e s . In addition, i t should be noted that where the case i s concerning tr a n s f e r p r i c i n g adjustments by section 482 of IRC, the Revenue Procedure 65-17 requires the taxpayer to f i l e a request f o r the treatment provided by the revenue procedure 122 9 7 before any cl o s i n g action i s taken on the section 482 issue. As an administrative practice, the IRS recommends i t s o f f i c i a l s to n o t i f y the taxpayer at the e a r l i e s t date to indicate the p o s s i b i l i t y of double taxation, necessary procedures to be taken by the taxpayer under Revenue Procedure 70-18 and 65-17, and the necessity of advice to the taxpayer's foreign a f f i l i a t e s . 5 . SUMMING UP I t can be said that the Canadian corresponding adjustment and mutual agreement procedure systems have been useful means for r e l i e v i n g taxpayers from double taxation, and Revenue Canada has been making strenuous e f f o r t s i n minimizing the various d i f f i c u l t i e s i n actual operation. Up to the present, at least between Canada and the U.S., due to good r e l a t i o n s h i p between Revenue Canada and the IRS and the e f f o r t s of the MNCs and tax pr a c t i t i o n e r s , there have been very few unrelievable double taxation cases a r i s i n g from transfer p r i c i n g adjustments. On the other hand, as the OECD 1984 Report indicates, there may be cases where MNCs unw i l l i n g l y accept the double taxation. Thus, the r e a l problems are not brought to the surface, leaving only a few unrelievable double taxation cases to be reported. Since the e x i s t i n g mutual agreement procedure i s seen as cumbersome, longwinded or u n l i k e l y to produce a useful r e s u l t i n a reasonable time, and domestic r e l i e f such as foreign tax 9 8 c r e d i t s may mitigate the e f f e c t of double taxation. However, i n 123 most cases, where Revenue Canada or a foreign tax authority attempts to make a transfer p r i c i n g adjustment, MNCs and tax p r a c t i t i o n e r s have usually been successful i n negotiating with the relevant tax aut h o r i t i e s and s e t t l i n g the case before irrevocable decisions are made. I t i s desirable that Canada should modernize i t s b i l a t e r a l tax conventions such as the Canada-U.S. Convention and Revenue Canada should improve the operation of the mutual agreement procedure, e s p e c i a l l y by speeding up i t s operation. At the same time, i t i s strongly recommended that Revenue Canada and relevant foreign competent au t h o r i t i e s , as well as Canadian taxpayers and t h e i r r e l a t e d p a r t i e s , s e t t l e a case before the formal mutual agreement procedure s t a r t s . In t h i s context, i t might be preferrable that mutual agreement procedure be used as a " l a s t 99 resort". 124 SUBCHAPTER V - FOOTNOTES Model Double Taxation Convention on Income and on Capital. Report of the OECD Committee on F i s c a l A f f a i r s (1977), at para. 2 of the Commentary on A r t i c l e 9 Transfer P r i c i n g , Corresponding Adjustments and the Mutual Agreement Procedure, Transfer P r i c i n g and Multinational  Enterprises: Three Taxation Issues. Report of the OECD Committee on F i s c a l A f f a i r s (1984), at para. 24 3 Ibid. para. 24 4 Ibid. para. 25 and 41 5 Ibid. para. 27 6 Ibid. para. 32 7 Ibid. para. 33 8 Ibid. para. 76 9 Ibid. para. 76 10 Ibid. para. 77 11 Ibid. para. 79 12 Ibid. para. 40 13 Ibid. para. 34 14 Ibid. para. 34 15 Ibid. para. 81 16 Supra, note 1, at para. 27 17 Supra, note 1/ at para. 47 18 Supra. note 2, at para. 36 19 Supra, note 2, at para. 36 20 Supra, note 2, at para. 37 21 Supra, note 2, at para. 41 125 22 Supra. note 2, at para. 42 23 Supra. note 2, at para. 58 24 Supra, note 2, at para. 48 25 Supra r note 2, at para. 47 26 Supra. note 2, at para. 47 27 Supra. note 2, at para. 48 28 Supra. note 2, at para. 48 29 Supra. note 2, at para. 51 30 Supra, note 2, at para. 55 31 Supra. note 2, at para. 63 32 Supra. note 1, at para. 45 33 Supra. note 2, at para. 35 34 Supra f note 2, at para. 40 35 Supra. note 2, at para. 56 36 Supra. note 2, at para. 40 37 Supra. note 2, at para. 69 38 Supra. note 2, at para. 82 39 Supra, note 2, at para. 82 40 Supra. note 2, at para. 83 41 Supra. note 2, at para. 86 42 Supra. note 2, at para. 89 43 Supra. note 2, at para. 84 44 Supra. note 2, at para. 90 45 Supra. note 2, at para. 91 46 Supra. note 2, at para. 92 47 Supra. note 2, at para. 93 48 Supra. note 2, at para. 93 of the Commentary on A r t i c l e 25 and 72 and 116 126 49 Suora. note 2, at para. 95 50 Supra. note 2, at para. 98 51 Supra. note 2, at para. 100 52 Supra. note 2, at para. 99 53 Supra. note 2, at para. 100 54 Supra. note 2, at para. 106 55 Supra, note 2, at para. 114 56 Supra, note 2, at para. 111 57 Supra f note 2, at para. 112 58 Supra. note 1, at para. 6 of 59 Supra. note 2, at para. 111 60 Supra, note 2, at para. 101 61 Supra. note 2, at para. 102 62 Supra. note 2, at para. 113 63 Supra. note 17 64 Paragraph 2 of A r t i c l e XXVI of the Canada-U.S. Income Tax Convention 65 Paragraph 3 of A r t i c l e IX of the Canada-U.S. Income Tax Convention 66 Supra, note 2, at para. 81 67 Subparagraph 152(4)(b) and section 172 of the Income Tax Act 68 The Technical Explanation on paragraph 4 of A r t i c l e IX of the Canada-U.S. Income Tax Convention 69 Supra. note 2, at para. 84 70 Paragraph 5 of A r t i c l e IX of the Canada-U.S. Inceme Tax Convention 71 The Technical Explanation on paragraph 3 of A r t i c l e XXVI of the Canada-U.S. Income Tax Convention 72 Paragraph 3 of A r t i c l e IX of the Canada-U.S. Income Tax 127 Convention 73 The Technical Explanation on paragraph 3 of A r t i c l e IX of the Canada-U.S. Income Tax Convention 74 Supra, note 1, at para. 11 of the Commentary on A r t i c l e 25 75 Supra. note 73 76 The Technical Explanation on paragraph 4 of A r t i c l e IX of the Canada-U.S. Income Tax Convention 77 For example, the Canada-U.K. Income Tax Convention, which was concluded i n 1978, has neither the provision of overriding by the mutual agreement procedure, nor the provision of the corresponding adjustment. 78 Revenue Canada, Requests f o r Competent Authority Considera-t i o n - Double Taxation Issue, Information C i r c u l a r 71-17R2 (1984), at para. 6 79 Ibid, para. 7 80 Ibid, para. 7 81 J . A. Calderwood, A Revenue Canada Perspective on the Role and Method of Operation of the "Competent Authority", Report  of the Proceedings of the T h i r t y - S i x t h Tax Conference. Canadian Tax Foundation (1984), at 320 82 Supra. note 78, at para. 11 83 Supra. note 78, at para. 12 and 13 84 Supra, note 78, at para. 12 85 Supra. note 78, at para. 13 86 Supra. note 78, at para. 14 and 16 87 Supra. note 78, at para. 15 88 Supra. note 78, at para. 16 89 Supra, note 78, at para. 15 90 Supra. note 78, at para. 15 91 The IRS, Revenue Procedure 70-18 (1970), at subsection 4.02 92 Ibid, subsection 4.03 93 Ibid, subsection 4.05 128 94 Ibid, subsection 4.05 95 Ibid, subsection 5.07 96 Ibid, subsections 4.08 and 4.09 97 I b i d f section 8 98 Supra. note 2, at para. 57 99 Supra. note 2, at para. 57 129 CHAPTER I I I THE JAPANESE NEW TRANSFER PRICING TAXATION SYSTEM 1. BACKGROUND Despite the fac t that Japanese economic a c t i v i t y has int e r n a t i o n a l i z e d rapidly, the Japanese tax system and i t s administration have not f u l l y caught up yet. For a cer t a i n period, MNCs e a s i l y committed tax avoidance or evasion through intra-group transactions with t h e i r s u b s i d i a r i e s i n tax haven countries. Honest taxpayers, due to the deficiency i n the tax system, have had to endure harsh assessments by the foreign tax aut h o r i t i e s and double taxation therefrom. Throughout a l l t h i s , Japanese government has been l o s i n g i t s due share of revenue. In 1978, Japan introduced anti-tax haven l e g i s l a t i o n under which undistributed income of a foreign subsidiary with i t s main o f f i c e i n "a low tax rate country" i s attr i b u t e d back to a domestic corporation i n proportion to that corporation's d i r e c t and/or i n d i r e c t ownership of the subsidiary's stock. 1 This anti-tax haven l e g i s l a t i o n has proved to be useful to some extent. However, the Japanese tax authority has not been able to solve the tr a n s f e r p r i c i n g problem yet. As the Japanese "export-oriented" economy increases i t s speed of i n t e r n a t i o n a l i z a t i o n , the p o s s i b i l i t y of s h i f t i n g of 2 p r o f i t s abroad through transfer p r i c i n g has grown. As discussed 130 i n the Japanese Diet, world-famous Japanese giant trading companies ("Sogo-shoshas"), have been paying only l i t t l e or no tax i n Japan by using generous foreign tax c r e d i t s system. In addition, the huge f i s c a l d e f i c i t along with recent aggressive assessments against Japanese taxpayers, to be exact, the U.S. sub s i d i a r i e s of Japanese companies by the IRS using section 482 of the IRC eventually made the Diet r e a l i z e the necessity of introducing transfer p r i c i n g taxation l e g i s l a t i o n . The l e g i s l a t i o n b i l l passed the Diet on March 28, 1986 and has been e f f e c t i v e since the beginning of A p r i l , 1986. 2. OVERVIEW OF THE SYSTEM Basic p r o v i s i o n B a s i c a l l y , the Japanese new transfer p r i c i n g taxation system i s s i m i l a r to that of Canada, the U.S. and other countries. I t adopts the arm's length p r i n c i p l e and uses s i m i l a r methods for find i n g an arm's length p r i c e as provided i n the Canadian IC 87-2 and the U.S. IRC Regulation. In p r i n c i p l e , Japan follows the ideas of the OECD reports. The basic provisions are provided i n A r t i c l e 66-5 of the Special Taxation Measures Law ("STML"). Paragraph 66-5(1) of the STML provides that where a corporation has conducted a sale or purchase of assets, provision of services or other transactions with i t s foreign a f f i l i a t e d corporation, i f the amount of consideration i s not an arm's 131 length p r i c e , and i f t h i s r e s u l t s i n reduction of the income of the corporation, the transaction ("foreign a f f i l i a t e d transac-tion") s h a l l be deemed to have been c a r r i e d out at an arm's length p r i c e f o r the purpose of corporate income taxation of the 4 corporation. The provisions are aimed at only corporations which bear tax l i a b i l i t y under the Corporation Tax Law ("CTL"). Not only domestic corporations but also foreign corporations which have a permanent establishment i n Japan (subparagraphs 141(i) through ( i i i ) of the CTL) or/and which have c a p i t a l gains from the d i s p o s i t i o n of immovable properties (subparagraph 141(iv) of the CTL) are included. This system i s also only applicable to the "foreign a f f i l i a t e d transactions", i . e . international transactions between par t i e s which are not dealing at arm's length. Since the concern i s to prevent the revenue loss, only international transactions which would r e s u l t i n reduction of taxable income i n Japan are subject to t h i s r u l e . Therefore, t h i s system does not apply to a transaction which i s equivalent to a domestic transaction i n e f f e c t . For example, where a domestic corporation and the branch of a foreign a f f i l i a t e d corporation make a transaction, i f that branch makes the transaction on i t s account and takes i t into c a l c u l a t i o n of i t s taxable income, i . e . the p r o f i t from the transaction i s to be attributed to the permanent establishment, such a transaction would not be subject to t h i s t ransfer p r i c i n g 5 taxation system. 132 Special r e l a t i o n s h i p To be 11 a foreign a f f i l i a t e d corporation ", the foreign corporation must have a "special r e l a t i o n s h i p " with a domestic corporation. A "special r e l a t i o n s h i p " i s defined i n A r i c l e 39-12 of the Special Taxation Measures Law Enforcement Order ("Enforce-ment Order"). Paragraph 39-12 (1) of the Enforcement Order provides that the " s p e c i a l r e l a t i o n s h i p s " s h a l l be the following r e l a t i o n s h i p s : (a) A r e l a t i o n s h i p i n which eithe r of two corporations owns, d i r e c t l y or i n d i r e c t l y , 50 percent or more of the t o t a l number of issued shares or the t o t a l amount of contributed c a p i t a l of the other corporation; (b) A r e l a t i o n s h i p i n which 50 percent or more of the t o t a l number of issued shares or the t o t a l amount of contributed c a p i t a l of two corporations are owned, d i r e c t l y or i n d i r e c t l y , by the same person; (c) A r e l a t i o n s h i p i n which eithe r of two corporations can, i n substance, determine a l l or a portion of the business p o l i c i e s of the other corporation. 6 In the case provided i n (a) and (b), the determination of d i r e c t or i n d i r e c t ownership percentage of a number of shares or an amount of contributed c a p i t a l s h a l l be made by adding the d i r e c t ownership percentage and the i n d i r e c t ownership percentage. To include the i n d i r e c t ownership percentage into the computation of ownership percentage, the i n d i r e c t owner must own 50 percent or more of issued shares, etc. of the corporation 133 which owns d i r e c t l y the other corporation i n question. For example, where Company A owns 60 percent of the issued shares of Company B and 10 percent of those of Company C, and Company B owns 40 percent of the issued shares of Company C, Company A's ownership percentage of the shares of Company C i s 50 percent. Accordingly Company A and Company C are i n a special 7 r e l a t i o n s h i p . (Company B and Company C are i n a special g r e l a t i o n s h i p as well.) As long as the chain-relationship i n which one corporation owns 50 percent or more of the issued shares, etc. of the other corporation e x i s t s , the i n d i r e c t ownership percentage through such a c a p i t a l a f f i l i a t e d corporation s h a l l be included into computation of ownership percentage of the corporation which owns the issued shares, etc. of that c a p i t a l a f f i l i a t e d corporations. For example, where Company A owns 50 percent of the issued shares of Company B, and Company B owns 50 percent of the issued shares of Company C, and Company C owns 50 percent of the issued shares of Company D, Company A and Company D are i n a sp e c i a l r e l a t i o n -ship. Where Company C owns 40 percent of the issued shares of Company D, i f Company A or Company B owns 10 percent or more of the issued shares of Company D, Company A and Company D are s t i l l 9 i n a s p e c i a l r e l a t i o n s h i p . In the case provided i n (b), i f the person i s an i n d i v i d u a l , a number of shares or an amount of contributed c a p i t a l owned by "in d i v i d u a l s who have a spe c i a l r e l a t i o n s h i p with the said i n d i v i d u a l as provided i n the cabinet order prescribed by Corporation Tax Law a t i c l e 2 ( x ) " 1 0 w i l l be included into the 134 computation of ownership percentage of the i n d i v i d u a l i n question. The sp e c i a l relationships i n t h i s case are as follows: (i) the r e l a t i v e s of the i n d i v i d u a l ; ( i i ) the commom-law spouse of the i n d i v i d u a l ; ( i i i ) the employee of the i n d i v i d u a l ; (iv) the person who i s dependent on the in d i v i d u a l ' s income, property, etc. for support (excluding those corresponding to a person l i s t e d i n (i) through ( i i i ) ) ; (v) the living-together r e l a t i v e s of those corresponding to a person l i s t e d i n (i) through ( i i i ) . 1 1 In the case provided i n (c), the existence of c a p i t a l r e l a t i o n s h i p i s not necessarily required. Arm's length p r i c e The concept of the arm's length p r i n c i p l e and methods of ca l c u l a t i n g an arm's length p r i c e follows the OECD Report and are si m i l a r to those of Revenue Canada's IC 87-2 and the U.S. IRC Regulation. In applying the methods, the transactions are divided into two types: the sale or purchase of inventory assets and other transactions. Paragraph 66-5(2) of the STML provides that: (i) In the case where a foreign a f f i l i a t e d transaction i s a sale or purchase of inventory assets, the following methods can be employed: (The method l i s t e d i n (d) can be employed only i n the case where the methods l i s t e d i n (a) through (c) cannot be used.) (a) Comparable Uncontrolled Price method: The method which uses, 1 3 5 as the arm's length amount of consideration i n the foreign a f f i l i a t e d transaction, an amount equivalent to the amount of the consideration which a s e l l e r and a buyer, who are not i n the sp e c i a l r e l a t i o n s h i p , agree i n sales of inventory assets of the same type as those i n the foreign a f f i l i a t e d transaction, under the circumstances such as commercial l e v e l , transaction volume, s i m i l a r to those i n the transaction i n question; (b) Resale Price Method: The method which uses, as the arm's length amount of consideration i n the foreign a f f i l i a t e d transaction, an amount computed by deducting a normal p r o f i t margin ( i . e . an amount computed by multiplying the resale price by a normal p r o f i t r a t i o ) , from the amount of consideration when a buyer of inventory assets involved i n the foreign a f f i l i a t e d transaction r e s e l l s those inventory assets to a person with whom he has no s p e c i a l r e l a t i o n s h i p ; (c) Cost Plus Method: The method which uses, as the arm's length amount of consideration i n the foreign a f f i l i a t e d transaction, the amount computed by adding a normal p r o f i t margin ( i . e . an amount computed by multiplying the amount of the costs by a normal p r o f i t r a t i o ) , to the amount of the costs of the s e l l e r to acquire by a purchase, manufacture, or other acts, the inventory assets involved i n the foreign a f f i l i a t e d transaction; (d) A method s i m i l a r to methods l i s t e d (a) through (c) above and other methods prescribed by cabinet order. ( i i ) In the case where a foreign a f f i l i a t e d transaction i s a transaction other than a sale or purchase of inventory assets, the following methods can be employed: (The methods l i s t e d i n (b) 136 can be employed only i n the case where the methods l i s t e d i n (a) cannot be used.) (a) A method which i s equivalent to a method l i s t e d i n (a) through (c) above; (b) A method which i s equivalent to a method l i s t e d i n (d) , 12 above. As stated before, the Japanese system adopted the "compara-able uncontrolled p r i c e " method, "resale p r i c e " method and "cost plus" method as basic methods to calculate an arm's length p r i c e . While the U.S. system has the order of p r i o r i t y i n application, under the Japanese system whichever i s the most reasonable i n a given case can be chosen. Necessary consideration to be given i n applying these methods i n an actual case i s b a s i c a l l y s i m i l a r to those provided i n the OECD Report. In the case of the comparable uncontrolled p r i c e method, where there i s a transaction i n which the inventory assets of the same type as those of the foreign a f f i l i a t e d transaction are sold under the circumstances d i f f e r e n t from those of the foreign a f f i l i a t e d transaction, i f i t i s possible to adjust the v a r i a t i o n i n the amount of consideration a r i s i n g due to such differences, 13 the comparable uncontrolled p r i c e method can s t i l l be used. "A normal p r o f i t r a t i o " i n the resale p r i c e method i s the r a t i o of the gross p r o f i t margin, ( i . e . , the amount computed by deducting, from the t o t a l amount of revenue from the transaction i n which the r e s e l l e r purchased inventory assets which are the same or s i m i l a r to the inventory assets involved i n the foreign a f f i l i a t e d transaction from a person with whom he has no spe c i a l 137 re l a t i o n s h i p ("un a f f i l i a t e d person"), s e l l s those inventory assets to an u n a f f i l i a t e d person, the t o t a l amount of costs of the inventory assets involved i n the transaction) to the above-mentioned t o t a l amount of revenues from the transaction. Where there are differences i n the functions performed by the s e l l e r or other matters as between the comparable transaction and the foreign a f f i l i a t e d transaction, i t i s necessary to make adjustments to r e f l e c t the v a r i a t i o n i n the r a t i o a r i s i n g due to 14 such differences. S i m i l a r i l y , "a normal p r o f i t r a t i o " i n the cost plus method i s the r a t i o of the gross p r o f i t margin, ( i . e . , the amount computed by deducting, from the t o t a l amount of revenues from the transaction, i n which the s e l l e r acquired inventory assets which are the same or s i m i l a r to the inventory assets involved i n the foreign a f f i l i a t e d transaction, by means of a purchase (from an u n a f f i l i a t e d person), manufacture or other acts, s e l l s those inventory assets to an u n a f f i l i a t e d person, the t o t a l amount of costs of the inventory assets involved i n the transaction) to the t o t a l amount of costs. As i n the resale p r i c e method, where there are differences i n the functions performed by the s e l l e r or other matters as between the comparable transaction and the foreign a f f i l i a t e d transaction, i t i s necessary to make adjust-ments to r e f l e c t the v a r i a t i o n i n the r a t i o a r i s i n g due to such 15 differences. As stated above, where none of these three methods are ava i l a b l e or reasonable, a method s i m i l a r to the three methods or other methods which are prescribed by cabinet order can be 138 u s e d . 1 6 The "methods prescribed by cabinet order" are methods which take an amount calculated by a t t r i b u t i n g the income from a purchase, manufacture, sale or other acts r e l a t i n g to the inventory assets involved i n the foreign a f f i l i a t e d transaction, to the corporation i n question and i t s foreign a f f i l i a t e d person according to the amount of expenses disbursed by, or the values of f i x e d assets used by the corporation and i t s foreign a f f i l i a t e d person for the purpose of those acts pertaining to the inventory assets, or other factors s u f f i c i e n t to presume the degree to which the corporation and i t s foreign a f f i l i a t e d person contributed to the r e a l i z a t i o n of the income, as the amount of 17 consideration i n the foreign a f f i l i a t e d transaction. The difference between the actual amount of consideration i n a foreign a f f i l i a t e d transaction and the arm's length p r i c e calculated by the above-mentioned methods s h a l l not be deductible for the purpose of computing the amount of income fo r the 18 business year of a corporation. Deemed Foreign A f f i l i a t e d Transaction I t often happens that the transaction between a corporation and i t s foreign a f f i l i a t e d corporation takes place through the t h i r d p a r t i e s . In Japan, international transactions by large corporations often take place through giant transnational trading companies c a l l e d "Sogo-shoshas". The conditions of such trans-actions are sometimes decided between the s e l l e r and ultimate purchaser i n substance and therefore the functions performed by Sogo-shoshas are so l i m i t e d that the p r o f i t margin or commission 139 received by them are low. Realizing that Sogo-shoshas usually cooperate with t h e i r c l i e n t s 1 business or accounting strategies, i t i s highly probable that MNCs do avoid the a p p l i c a t i o n of tra n s f e r p r i c i n g taxation by executing transactions through the trading companies. To plug the loopholes, the Japanese system has a special provision i n which a c e r t a i n transaction with a t h i r d party w i l l be deemed to be a " a f f i l i a t e d foreign transaction". Paragraph 66-5(5) of the STML provides that i n c e r t a i n cases where a corporation conducted a transaction with i t s foreign a f f i l i a t e d person through an u n a f f i l i a t e d person, the transaction between the corporation and the the u n a f f i l i a t e d person s h a l l be 19 deemed to be a foreign a f f i l i a t e d transaction. Paragraph 39-12(9) of the Enforcement Order provides s p e c i f i c conditions: (a) the sale, assignment, lending or provision, between a corpo-r a t i o n and i t s foreign a f f i l i a t e d person, of the assets which are the subject of the transaction between the corporation and the u n a f f i l i a t e d person, or between the foreign a f f i l i a t e d person and the u n a f f i l i a t e d person had already been decided, pursuant to a contract or i n another manner, as of the time the transaction was conducted; and (b) the amount of consideration i n the transaction i s recognized as having been determined, i n substance, between the corporation . . 20 and i t s foreign a f f i l i a t e d person. Even i n the cases where i t i s reasonable to conduct a transaction through an u n a f f i l i a t e d person, i f such a case meets 140 the above-mentioned conditions, the transaction w i l l be deemed to 21 be a foreign a f f i l i a t e d transaction. The arm's length p r i c e i n the "deemed foreign a f f i l i a t e d transaction" s h a l l be the amount computed by making necessary adjustments f o r the difference i n the amount of consideration which a r i s e s due to the fact that the transaction between the corporation and i t s foreign a f f i l i a t e d corporation i s conducted through an u n a f f i l i a t e d person, to the amount computed by deeming the transaction as having been conducted between the corporation 22 and i t s foreign a f f i l i a t e d person. Presumption Provision Since most of information needed to c a l c u l a t e an arm's length p r i c e are held i n the taxpayer's hands, the taxpayer's cooperation with the tax a u t h o r i t i e s i n providing information i s important f o r a f a i r and reasonable a p p l i c a t i o n of the transfer p r i c i n g taxation system. However, taxpayers are not always cooperative with the tax a u t h o r i t i e s and even i f they were to t r y to provide information, i t would be impossible i n those cases where information regarding taxpayer's foreign a f f i l i a t e d person, e s p e c i a l l y parent company, i s required. Moreover, i n Japan, the burden of proof i s , generally speaking, thought to be l a i d on the tax authority's side. In view of the above-mentioned si t u a t i o n s , Japan introduced a "presumption" provision which considered a landmark i n the area of Japanese tax law. 141 Paragraph 66-5(6) of the STML provides that where the tax authority has requested the corporation to provide information which are necessary for computing the arm's length p r i c e i n the foreign a f f i l i a t e d transaction, i f the corporation does not provide them without delay, the tax authority can correct the amount of income of that corporation, by presuming to be the arm's length p r i c e that amount which i s computed by the resale p r i c e method, the cost plus method, or other equivalent methods. In computing such an amount, the gross sales p r o f i t r a t i o or a r a t i o prescribed by cabinet order as a r a t i o corresponding thereto, of the business a c t i v i t y of a corporation engaging i n a business a c t i v i t y which i s of the same type as that involving the foreign a f f i l i a t e d transaction of the corporation i n question and of which the scale of business and other contents of i t s business a c t i v i t i e s are s i m i l a r , w i l l be used as the basis. The p r i c e thus calculated i s presumed v a l i d and the taxpayer challenging i t s v a l i d i t y has to produce evidence to support his 23 arguments. "The gross sales p r o f i t r a t i o or a r a t i o prescribed by 24 cabinet order as a r a t i o corresponding thereto" i s the r a t i o of the amount of gross sales p r o f i t s of a corporation which i s engaged i n a business a c t i v i t y of the same type and of which the scale of business and other contents of i t s business a c t i v i t y are si m i l a r , f o r the business year including the date on which the foreign a f f i l i a t e d transaction was conducted (or for such period corresponding thereto), to the amount of t o t a l gross revenues (in the case of the resale p r i c e method) or the amount of t o t a l costs 142 (in the case of the cost plus method) pertaining to the business a c t i v i t y . 2 5 I t should be based on the facts and circumstances of each case to determine whether the p a r t i c u l a r corporation i s engaging i n a business a c t i v i t y which i s of the same type as the business a c t i v i t y involving the foreign a f f i l i a t e d transaction of the corporation and of which the scale of business and other contents of i t s business a c t i v i t y are s i m i l a r or not. Since t h i s presumption provision i s unusual i n the Japanese tax law, corporate taxpayers concerned that t h i s provision i s too aggressive a system. In addition, as stated before, information required by the tax authority might not be avail a b l e f o r the taxpayers, and accordingly , i t i s important that taxpayers should not be overburdened. However, considering that under the Canadian Income Tax Act the burden of proof i s , generally, l a i d on taxpayer's side and under the U.S. IRC, i n addition to the taxpayer's burden of proof, i f the taxpayer f a i l s to comply with the formal document request by the IRS i n i t s examination before the 90th day a f t e r the date of the mailing of a request, any court which deals with the tax case s h a l l p r o h i b i t the introduc-t i o n by the taxpayer of any foreign-based documentation covered 26 by such a request. I t can be said that the presumption prov i s i o n i s indispensable and reasonable for the e f f e c t i v e enforcement of the transfer p r i c i n g taxation system. Provision of information by taxpayers In addition to the presumption provision, the Japanese 143 t r a n s f e r p r i c i n g taxation system set up two other provisions concerning c o l l e c t i o n of information. The f i r s t one concerns foreign-based information. Paragraph 66-5 (7) of the STML provides that o f f i c i a l s of the National Tax Administration may request a corporation to provide the information over which i t s foreign a f f i l i a t e d person maintain custody, i f i t i s necessary f o r auditing the foreign a f f i l i a t e d transaction between the corporation and i t s foreign a f f i l i a t e d 27 person. Before the introduction of t h i s provision, Japanese Corpora-t i o n Tax Law already had a provision i n which the tax authority i s authorized to inquire a taxpayer or a person with whom the taxpayer made a transaction and to inspect necessary documents of 28 the taxpayer or the person. However, since i t i s important to obtain foreign-based information such as the ledgers of a foreign a f f i l i a t e d corporation for the e f f e c t i v e enforcement of the trans f e r p r i c i n g taxation system, t h i s new provision was added. This provision does not impose penalties on the taxpayers i f they cannot or do not provide the information. In other words, the taxpayer only has to "endeavor to obtain said records and books, 29 or copies thereof." However, i f such information i s necessary for the purpose of computing the arm's length p r i c e , the presump-t i o n provision w i l l apply. The other provision concerns "periodic information returns". Paragraph 66-5(8) of the STML requires the corporation i f i t has conducted foreign a f f i l i a t e d transactions during the business year, to attach a document which contains the name and location 144 of the head o f f i c e of i t s foreign a f f i l i a t e d corporation and 30 other items to i t s f i n a l tax return f o r the business year. Corresponding adjustment and mutual agreement procedure The new t r a n s f e r p r i c i n g taxation system b i l l also includes provisions concerning the corresponding adjustment and mutual agreement procedure. P r i o r to t h i s new l e g i s l a t i o n , because Japan reserved the r i g h t not to i n s e r t paragrah 9(2) of the OECD Convention into i t s b i l a t e r a l tax convention and most of present b i l a t e r a l tax con-ventions which Japan concluded do not have the corresponding adjustment provisions, the l e g a l authority to make corresponding adjustments has been based on the i n t e r p r e t a t i o n of the provision on the l i n e of A r t i c l e 25 of the OECD Convention i n i t s b i l a t e r a l 31 tax convention. The new l e g i s l a t i o n c l e a r l y confirms l e g a l authority i n a written l e g i s l a t i v e form. Paragraph 7(1) of the Law for Enforce-ment of Tax Treaties provides that where one of Contracting States of tax t r e a t i e s of Japan, makes an adjustment on the actual amount of consideration i n the transaction between a resident of Japan and the resident of that State when determining taxable income of the resident of that State, i f the competent au t h o r i t i e s of Japan and that State come to an agreement based on the provisions of the tax treaty with respect to the amount of consideration on which the taxable income i s determined, the D i s t r i c t Director s h a l l be able to correct the amount of taxable income of the resident of Japan taking as the basis the amount of 145 consideration which i s i n the above-mentioned agreement, replying to the request for correction submitted by that resident of Japan. In other words, the following conditions must be met: (a) The country which has a tax treaty with Japan makes a tra n s f e r p r i c i n g adjustment i n the transaction between a resident of Japan and a resident i n the country. In t h i s case, the tax treaty must have a provision recognizing the arm's length p r i n c i p l e such as paragraph 9(1) of the OECD Convention as well as the provisions for the mutual agreement procedure; (b) The competent authorities of both Japan and that country must reach an agreement. Needless to say, the new l e g i s l a t i o n w i l l not impose on the competent authority the obl i g a t i o n to make a corresponding adjustment or reach an agreement; (c) The agreement reached by the competent au t h o r i t i e s must be accepted by the taxpayers and the resident of Japan must f i l e the request f o r correction to the Japanese tax authority. The taxpayer does not have to accept the agreement. I f the contents of the agreement reached by the competent au t h o r i t i e s are not acceptable to the taxpayer, he can choose to pursue r e l i e f i n the 32 courts. Corresponding adjustments s h a l l be done by r e c a l c u l a t i n g the income using the revised p r i c e which was agreed by the competent aut h o r i t i e s as the arm's length p r i c e and s h a l l be made for the 33 past business year respectively. There i s no difference i n the way of adjustments, whether the cash flow corresponding to the i n i t i a l adjustment i s r e a l i z e d 146 or not. However, i n the case that the taxpayer does not return the amount by which i t s income was reduced, such amount s h a l l be included into i t s retained earnings and i n the case of "a family 3 4 corporation", into i t s undistributed p r o f i t s . Procedures to be taken bv the taxpayer to request competent  authority consideration A r t i c l e 12 of M i n i s t e r i a l Ordinance Implementing the Law for Enforcement of Tax Treaties provides the necessary procedure to be taken by a taxpayer who makes a request f o r competent authority consideration. In a prescribed form, the taxpayer must f i l l i n the following items: (a) the name and address of i t s head o f f i c e or place of central management and con t r o l ; (b) the facts and circumstances under which the assessment which i s not i n accordance with the provision of the tax treaty was made or i s going to be made; (c) the business year during which the assessment r e l a t e s . At the same time, the taxapyer i s required to attach necessary documents to the applic a t i o n . Where an agreement i s reached between the competent author-i t i e s and i t i s acceptable for the taxpayer, he has to f i l e a request f o r correction within two months from the following day 3 5 of the date at which the agreement was reached. I t should be noted that under the Japanese system a taxpayer can get r e l i e f from double taxation through corresponding adjust-147 merits regardless of the ordinary statutory l i m i t a t i o n as long as the taxpayer has evidence to support h i s claim. That i s to say, the agreement reached by mutual agreement procedures overrides domestic time l i m i t s . However, the taxpayer has to be careful about the time l i m i t s on a request for competent authority 3 6 consideration provided i n b i l a t e r a l tax t r e a t i e s . 3. ADMINISTRATIVE PRINCIPLES AND GUIDELINES The National Tax Administration's stance The National Tax Administration of Japan ("NTA") had been considering the p r i n c i p l e s and guidelines to be followed i n the actual a p p l i c a t i o n of the transfer p r i c i n g taxation system. I t came to the conclusion that the following two p r i n c i p l e s should be s t r i c t l y observed: (a) To neutralize, as much as possible, the e f f e c t s of transfer p r i c i n g taxation on legitimate economic decisions and a c t i v i t i e s , and to secure f a i r and reasonable assessments, which w i l l encourage the long-term voluntary compliance of taxpayers; i n t h i s regard, (i) the concept of the arm's length p r i c e should be defined with a reasonable range and, ( i i ) to be a f a i r and reasonable assessment, i t should be f u l l y backed by economic theory, analysis and accounting or s t a t i s t i -c a l data. (b) To minimize excessive and c o s t l y administrative burdens on 148 taxpayers, while securing information e s s e n t i a l f o r f a i r , j u st 37 and reasonable tax adjustments. Following these basic p r i n c i p l e s , the NTA w i l l put emphasis on the following areas: (a) confirmation system, (b) close moni-38 t o r i n g by the headquarter and (c) international cooperation. Confirmation System This i s a system of confirming proposals by taxpayers on the pr i c e c a l c u l a t i o n method and the required information. This system should be introduced for the purpose of preventing the occurrence of tra n s f e r p r i c i n g taxation cases which would be very c o s t l y and time-consuming f o r both taxpayers and tax authorities, eliminating as much as possible uncertainties i n international transactions by se t t i n g rules of the game through confirmations. Under t h i s system, a taxpayer would propose to the NTA a method of determining the arm's length p r i c e which he thinks i s most reasonable and the scope of the es s e n t i a l information he i s w i l l i n g to provide. The NTA w i l l then undertake in-depth studies on the economic r e a l i t y of the relevant i n d u s t r i e s . Based on the studies, i f the NTA finds the proposal reasonable, i t w i l l give the taxpayer a sort of confirmation. To give a complete c o n f i r -mation to the taxpayer, the NTA must at lea s t to get i n advance an informal concurrence or t a c i t understanding on the proposal from the relevant foreign tax au t h o r i t i e s . However, since tax systems and administrative practices may vary by each country, i t might be d i f f i c u l t to get such a concurrence i n advance from the 149 39 foreign tax a u t h o r i t i e s . Since the transfer p r i c i n g taxation l e g i s l a t i o n had just become e f f e c t i v e on A p r i l 1, 1986, the s p e c i f i c procedures are s t i l l under consideration. Close monitoring bv the tax authority's headquarter According to the understanding of the NTA, tr a n s f e r p r i c i n g taxation cases should be supervised c l o s e l y or taken over at an early stage by the headquarters of the tax au t h o r i t i e s , so that u n j u s t i f i a b l e adjustments can be prevented i n advance, at least u n t i l guidelines on transfer p r i c i n g taxation are firmly established for the reason that: (a) The tra n s f e r p r i c i n g provision i s novel l e g i s l a t i o n f o r Japan and NTA's f i e l d s t a f f requires time to accumulate actual experience; (b) Other countries' experiences show that prolonged and co s t l y delays i n the f i e l d could have been prevented i f the tax authority's headquarter had been involved e a r l i e r , before an irrevocable decision was made; (c) Transfer p r i c i n g taxation e n t a i l s international aspects such as corresponding adjustments which are generally handled only by 40 the headquarters. Considering that unlike the other foreign tax authorities, NTA's degree of c e n t r a l i z a t i o n i s f a i r l y high, and corporations with a share c a p i t a l of more than 100 m i l l i o n yen, which are most of the corporations which make foreign a f f i l i a t e d transactions, are under the j u r i s d i c t i o n of the audit department of the 150 regional taxation bureaus, i t i s both easy and reasonable for the headquarter to monitor those cases. Such monitoring would also benefit the taxpayer, since i t w i l l ensure the consistent application of the system and w i l l also l i m i t the number of contact points. International cooperation The NTA w i l l make e f f o r t s with other tax authorities to es t a b l i s h common rules on tran s f e r p r i c i n g taxation to f a c i l i t a t e cooperation. The reasons why the NTA considers such e f f o r t s to be e s s e n t i a l are as follows: (a) The differences i n rules, practices and int e r p r e t a t i o n between the tax treaty partners could be very c o s t l y and time-consuming f o r taxpayers as well as for tax au t h o r i t i e s ; (b) Foreign-based information i s often c r u c i a l i n transfer p r i c i n g taxation cases. Cooperation based on common rules of basic information exchange would be h e l p f u l f or f a i r and e f f i c i e n t enforcement; (c) Common understanding and close coordination with treaty partners are prerequisites f o r the proposed "confirmation" 41 system. To augment cooperative re l a t i o n s h i p s with foreign tax aut h o r i t i e s , the NTA, has started semi-annual high l e v e l face-to-face meetings and has concluded an agreement on a simultaneous examination program with the U.S. IRS. A series of industry-wide p r i c i n g studies with IRS which can be expected to lead to the etablishment of common guidelines on p r i c i n g , e s p e c i a l l y on safe 151 haven rules, and the spontaneous exchange of information on tra n s f e r p r i c i n g cases at an early stage are under consider-a t i o n . 4 2 In addition, the NTA w i l l continue to p a r t i c i p a t e i n such multinational conferences as the OECD, the PATA ( P a c i f i c Associ-ation of Tax Administrators) and the SGATAR (Study Group on Asian 43 Tax Administration and Research) meetings. As to the exchange of information under the provisions of the tax t r e a t i e s , the NTA has been making and w i l l make e f f o r t s to improve the qu a l i t y as well as the quantity of the information. P r a c t i c a l methods to derive an arm's length p r i c e The NTA i s looking f o r reasonable ways to derive an arm's length p r i c e at the administrative l e v e l s . Considering the d i f f i c u l t i e s of determining an arm's length p r i c e already experienced i n the U.S. and other countries, the NTA seems to come to the following conclusion: i t i s almost impossible to f i n d 44 a "genuine" comparable uncontrolled p r i c e and even a 45 "so-called" comparable uncontrolled p r i c e might not always be 46 a v a i l a b l e . I t becomes a l l the more important to f i n d a fe a s i b l e way to a r r i v e at a reasonable margin r a t i o i n the resale price method and cost plus method. There are two methods: (a) The f i r s t method i s to average prices of as many si m i l a r products or transactions as possible. In t h i s case, since i t would be inappropriate and negligent of actual economic s i t u a t i o n s i f the tax authority r i g i d l y make a tran s f e r p r i c i n g 152 adjustment simply because the actual p r i c e i s s l i g h t l y d i f f e r e n t from the si n g l e average figure thus arr i v e d at, a more appropriate way would be to set a range centering around the average figure. An examination of the taxpayer would s t a r t only i n cases where an actual transaction p r i c e i s beyond t h i s range. In other words, the range should be used as a t r i g g e r , and unless proved otherwise a transfer p r i c e adjustment w i l l be made i f the 47 range i s exceeded; (b) The second method i s to pick up a transaction most s i m i l a r to the transaction i n question, and derive the arm's length price range through the following two steps: (i) F i r s t , make appropriate adjustments to account f o r q u a n t i f i -able differences between the sample transaction and the trans-action i n question; and ( i i ) Second, allow a reasonable amount of allowance to make up for any unquantifiable but c l e a r l y e x i s t i n g q u a l i t a t i v e differences. Under t h i s second method, a tran s f e r p r i c i n g adjustment should be made only i n a case where the actual p r i c e i n question i s beyond 48 t h i s allowance. The above-mentioned methods follow the idea of the OECD 49 Report. In addition, even i n cases where one of the basic methods i s u t i l i z e d to determine the arm's length p r i c e , the NTA r e a l i z e s that i t i s necessary to check the reasonableness of the determined p r i c e by using other f e a s i b l e methods such as the 50 return on investment method and the p r o f i t a l l o c a t i o n method. 153 However, where the tax authorities have to use the p r o f i t a l l o c a t i o n method, the c a l c u l a t i o n should be made by thorough, complete functional analysis which r e f l e c t s the r e a l contribution or importance of the various a c t i v i t i e s or functions performed by the relevant corporation, and take into account the differences i n management p o l i c y of the corporation or MNC and i n a national market. 5 1 4 . Comparison of the Japanese system and Canadian system The basic structure and methods of c a l c u l a t i n g an arm's length p r i c e of the Japanese system are s i m i l a r to those of the Canadian system. However, the following differences can be pointed out: Scope of the p r o v i s i o n While the Japanese system only applies to a "foreign" a f f i l i a t e d transaction conducted between a "corporation", which bears the tax l i a b i l i t y under the Japanese Corporation Tax Law, 52 and i t s foreign a f f i l i a t e d "corporation", section 69 of the Income Tax Act applies to any transactions between pa r t i e s which 53 are not dealing at arm's length. Since the Japanses tax authority aims with t h i s system to prevent the Japanese taxpayers from s h i f t i n g t h e i r income abroad, i t might be reasonable to l i m i t the ap p l i c a t i o n of the system to foreign transactions. However, considering the f a c t that more 154 than 50 percent of Japanese corporations are reporting losses at present, there may be the p o s s i b i l i t y of minimizing tax l i a b i l i t i e s as a group by manipulating the tra n s f e r prices i n 54 domestic intra-group transactions. Accordingly, from the viewpoint of the revenue au t h o r i t i e s , the app l i c a t i o n of the tra n s f e r pricng taxation system should be extended to domestic transactions. The reason why the Ministry of Finance l i m i t s the app l i c a t i o n of the system to a transaction between corporations i s not cl e a r . Although i t can be expected that most of the foreign a f f i l i a t e d transactions are conducted by large corporations and the magnitude of tax planning using indiv i d u a l s to escape t h i s system are not s i g n i f i c a n t , I am a f r a i d that t h i s "deficiency" w i l l provide tempting loopholes for taxpayers. In t h i s context, the Canadian system may be a more convenient and e f f e c t i v e weapon for tax a u t h o r i t i e s . D e f i n i t i o n of "non-arm's le n q t h w While the Japanese system defines " s p e c i a l r e l a t i o n s h i p s " f a i r l y p r e c i s e l y i n the STML and the Enforcement Order, sub-section 251(1) of the Income Tax Act defines the concept of "arm's length" i n rather a broad manner. Taking into account other provisions of the Income Tax Act and the f l e x i b l e a p p l i c a t i o n of the "substantial c o n t r o l " provision of the 55 Enforcement Order, the actual e f f e c t of both system might be s i m i l a r i n terms of taxpayer's p r e d i c t a b i l i t y and certainty. However, there may be a l i m i t a t i o n on the f l e x i b l e a p p l i c a t i o n of 155 the substantial control provision by the NTA. R e a l i z i n g that by v i r t u e of paragraph 251(1)(b) of the Income Tax Act, Revenue Canada can apply section 69 to any transactions t h e o r e t i c a l l y , i t can be said that the Japan system should contain such a general provision as paragraph 251(1)(b) of the Income Tax Act, although i t s precise d e f i n i t i o n i s quite reasonable from the taxpayer's viewpoint. Deemed foreign a f f i l i a t e d transactions As stated above, Japan introduced the "deemed foreign a f f i l i a t e d transaction" provision to plug the loopholes with which taxpayers can escape the application of t r a n s f e r p r i c i n g taxation system by conducting intra-group transactions through t h i r d p a r t i e s . In Japan, most of large corporations belong to one of several corporate groups. Such a corporate group consists of a bank, trading company, insurance company, shipping company, major manufacturing companies. Due to the Japanese anti-monoply l e g i s l a t i o n , shareholding companies are prohibited and the share c a p i t a l of each member corporation are usually owned by more than twenty other members of the group and the ownership percentage of each member i s less than 5 percent. Accordingly, there i s no central management and control i n the group and i n most cases, member corporations are not i n a "special r e l a t i o n s h i p " . However, members cooperate with each other and have considerably close business r e l a t i o n s h i p s . Above a l l , trading companies ("Sogo-shoshas") perform a key r o l e i n coordinating the business 156 a c t i v i t i e s of the group and most of international transactions of member companies are conducted through Sogo-shoshas. Therefore, i t can be said that the deeemed foreign a f f i l i a t e d transaction provision i s reasonable and indispensable for the f a i r and e f f e c t i v e enforcement of the transfer p r i c i n g taxation system. However, t h i s provision a p l l i e s to the case where an intra-group transaction i s conducted through "one" u n a f f i l i a t e d person. Accordingly, a taxpayer may escape the a p p l i c a t i o n of t h i s provision by conducting a transaction more than two u n a f f i l i a t e d persons, although such tax planning might be cumbersome. The Canadian system does not have the provision equivalent to the deemed foreign a f f i l i a t e d transaction provision. Revenue Canada may, however, cope with the transfer p r i c i n g scheme using t h i r d p a r t i e s by f l e x i b l e i n t e r p r e t a t i o n of section 251 and other anti-avoidance provisions of the Income Tax Act. SUMMING UP I t can be said that the Japanese new t r a n s f e r p r i c i n g taxation l e g i s l a t i o n i s f a i r l y reasonable. Although, the basic structure and methods to c a l c u l a t e an arm's length p r i c e are s i m i l a r to those of Canada and the U.S., the Japanese approach i n which the d e t a i l e d provisions are written into the law i s preferrable for the taxpayers' convenience and maintain the p r i n c i p l e of "no taxation without law". 5 6 On the other hand, from the viewpoint of the tax authority, 157 although the presumption provision i s epoch-making i n the hist o r y of Japanese tax law a f t e r World War I I , i t can be said that Japan should have introduced more general provisions which allow the NTA more f l e x i b l e enforcement of the system. I t should be noted that both the Japanese and Canadian tr a n s f e r p r i c i n g taxation systems, unlike the U.S. system, do not provide f o r the r e a l l o c a t i o n of income or deduction among related e n t i t i e s . 158 CHAPTER I I I - FOOTNOTES 1 An Outline of Japanese Taxes 1986. Tax Bureau of the Ministry of Finance, Japan, at 99 2 Ibid. 100 3 T. K i r i b u c h i , Japan's Transfer Pricincr Taxation: Introduction  and Enforcement, International Tax I n s t i t u t e Seminar on Transfer P r i c i n g Taxation (1986) , at para. 3 4 Paragraph 66-5(1) of the STML: In the event that, during a business year commencing on or a f t e r A p r i l 1, 1986, a corporation has conducted the sale of assets, the purchase of assets, the provision of services or other transactions with a foreign a f f i l i a t e d person of said corporation (meaning a foreign corporation provided i n a r t i c l e 2 (1) ( i i ) (hereafter i n t h i s a r t i c l e referred to as "foreign corporation") which has a r e l a t i o n s h i p with said corporation i n which eith e r corporation, d i r e c t l y or i n d i r e c t l y , owns a number of shares or an amount of contributed c a p i t a l comprising 50 percent or more of the t o t a l number of issued shares or t o t a l amount of contributed c a p i t a l of the other corporation or has any other special r e l a t i o n s h i p with said corporation as provided by cabinet order (hereafter i n t h i s a r t i c l e referred to as "special r e l a t i o n s h i p " ) ; hereafter i n t h i s a r t i c l e , the same) and, i n connection with said transaction (excluding those transactions which give r i s e to domestic source income of said foreign a f f i l i a t e d person as l i s t e d i n Corporation Tax Law a r t i c l e 141 (i) through ( i i i ) depending upon whether said foreign a f f i l i a t e d person corresponds to a foreign corporation l i s t e d i n said subparagraphs (i) through ( i i i ) and which are prescribed by cabinet order; hereinafter referr e d to as "foreign a f f i l i a t e d transaction"), i f the amount of consideration of which payment was received by said corporation from said foreign a f f i l i a t e d person was less than an arm's length p r i c e , or i f the amount of consideration which said corporation paid to said foreign a f f i l i a t e d person was greater than an arm's length p r i c e , then, f o r purposes of a p p l i c a t i o n of the provisions of the Corporation Tax Law and other laws and regulations concerning the corporation tax with regard to the income fo r the said business year or the l i q u i d a t i o n income (including income of the business year during l i q u i d a t i o n of a corporation subject to the corporation tax on l i q u i d a t i o n income and amounts deemed to be l i q u i d a t i o n income due to d i s s o l u t i o n pursuant to the 159 provisions of Corporation Tax Law a r t i c l e 103 ( 1 ) ( i i ) ; the same f o r paragraph (6)) due to the d i s s o l u t i o n (excluding d i s s o l u t i o n s pursuant to merger; hereafter i n t h i s a r t i c l e , the same), said foreign a f f i l i a t e d transaction s h a l l be deemed to have been c a r r i e d out at an arm's length p r i c e . ( The English text of the Japanese transfer p r i c i n g taxation l e g i s l a t i o n i s based on the t r a n s l a t i o n by Mr. G. M. Thomas and Mr. K. Aramaki. ("Transfer P r i c i n g L e g i s l a t i o n " , Inter- national Taxation (special issue) (1986), at 4-23)) 5 S. Odajima, Transfer P r i c i n g Taxation, International Taxation  (special issue) (1986) , (Japanese text) at 24 6 Paragraph 39-12(1) of the Enforcement Order: The s p e c i a l r elationships to be provided by cabinet order as prescribed by Special Taxation Measures Law a r t i c l e 66-5(1) s h a l l be the relationships l i s t e d below: (i) A r e l a t i o n s h i p i n which eith e r of two corporations owns, d i r e c t l y or i n d i r e c t l y , a number of shares or an amount of contributed c a p i t a l comprising 50 percent or more of the t o t a l number of issued shares or t o t a l amount of contributed c a p i t a l ( h e r e a f t e r i n t h i s a r t i c l e c a l l e d "issued shares, etc.") of the other corporation. ( i i ) A r e l a t i o n s h i p i n which a number of shares or an amount of contributed c a p i t a l comprising 50 percent or more of the issued shares, etc. of two corporations are owned, d i r e c t l y or i n d i r e c t l y , by the same person (in the event said person i s an i n d i v i d u a l , said i n d i v i d u a l and i n d i v i d u a l s who have a spec i a l r e l a t i o n s h i p with said i n d i v i d u a l as provided i n the cabinet order prescribed by Corporation Tax Law a r t i c l e 2(x)) (excluding those corresponding to a r e l a t i o n s h i p l i s t e d i n the preceding subparagraph). ( i i i ) A r e l a t i o n s h i p i n which, due to the existence of the facts l i s t e d below or other facts s i m i l a r thereto, e i t h e r of two corporations can, i n substance, determine a l l or a portion of the business p o l i c i e s of the other corporation (excluding those corresponding to a r e l a t i o n s h i p l i s t e d i n the preceding two subparagraphs). (a) An o f f i c e r with authority to represent, or one h a l f of more of the o f f i c e r s of, said other corporation (is)/[are] (a) person[s] who (is)/[are] concurrently employed as (an) o f f i c e r [ s ] or employee[s] of the said corporation or (a) person[s] who (was)/[were] (an) o f f i c e r [ s ] or employee[s] of said corporation. (b) Said other corporation conducts a considerable portion of i t s business a c t i v i t i e s i n reliance upon transactions with said corporation. (c) Said other corporation procures a considerable portion of the funds which are necessary f o r i t s business a c t i v i t i e s by means of borrowing from said corporation or by receiving the guarantees of said corporation. 7 Paragraph 39-12(2) of the Enforcement Order 160 8 Subparagraph 39-12(1)(ii) of the Enforcement Order 9 Subparagraph 39-12(3)(ii) of the Enforcement Order 10 Subparagraph 39-12(1)(ii) of the Enforcement Order 11 Paragraph 4(11) of the Corporation Tax Law Enforcement Order 12 Paragraph 66-5(2) of the STML: The arm's length p r i c e provided i n the preceding paragraph s h a l l mean the amount which i s computed i n accordance with a method l i s t e d i n the following subparagraphs, depending upon whether the foreign a f f i l i a t e d transaction corresponds to the transaction l i s t e d i n the following subparagraphs: (i) Sale or purchase of inventory assets prescribed i n Corporation Tax Law a r i c l e 2 (xxi)(hereafter referred to as "inventory assets"): the following methods (the methods l i s t e d i n (d) can be employed only i n the case that the methods l i s t e d i n (a) through (c) cannot be used): (a) Comparable uncontrolled p r i c e method (meaning the method which uses, as the amount of consideration i n s a i d foreign a f f i l i a t e d transaction, an amount equivalent to the amount of consideration i n a transaction i n which a s e l l e r and a buyer who were not i n a special r e l a t i o n s h i p engaged i n sales of inventory assets which were of the same type as the inventory assets involved i n said foreign a f f i l i a t e d transaction, under circumstances such as commercial l e v e l , transaction volume, and other circumstances which were s i m i l a r to those i n said foreign a f f i l i a t e d transaction including the amount of consideration a f t e r making adjustments, i n the event that there i s a transaction i n which said inventory assets of the same type were sold under circumstances i n which there were differences from said foreign a f f i l i a t e d transaction i n commercial l e v e l , transaction volume, and other such circumstances and i t i s possible to adjust the v a r i a t i o n i n the amount of consideration a r i s i n g due to such d i f f e r e n c e s ) ) . (b) Resale p r i c e method (meaning the method which uses, as the amount of consideration i n said foreign a f f i l i a t e d transaction, an amount computed by deducting, from the amount of consideration f o r which a buyer of inventory assets involved i n a foreign a f f i l i a t e d transaction sold sa i d inventory assets to a person with which i t had no s p e c i a l r e l a t i o n s h i p (hereafter i n t h i s paragraph referred to as the "resale p r i c e " ) , a normal p r o f i t margin (meaning an amount computed by multiplying said resale p r i c e by a normal p r o f i t r a t i o prescribed by cabinet order)). (c) Cost plus method (meaning the method which uses, as the amount of consideration i n said foreign a f f i l i a t e d transaction, the amount computed by adding, to the amount of the costs of the s e l l e r to acquire by purchase, manufacture, or other acts the inventory assets involved i n 161 said foreign a f f i l i a t e d transaction, a normal p r o f i t margin (meaning an amount computed by multiplying said amount of costs by a normal p r o f i t r a t i o prescribed by cabinet order)). (d) A method s i m i l a r to the methods l i s t e d i n (a) through (c) above and other methods prescribed by cabinet order, ( i i ) Transactions other than those l i s t e d i n the preceding subparagraph: The methods l i s t e d below (the method l i s t e d i n (b) can be employed only i n the case that the method l i s t e d i n (a) cannot be used): (a) A method which i s equivalent to a method l i s t e d i n (a) through (c) i n the preceding subparagraph. (b) A method which i s equivalent to a method l i s t e d i n (d) of the preceding subparagraph. 13 Subaragraph 66-5(2)(1)(a) of the STML 14 Paragraph 39-12(6) of the Enforcement Order 15 Paragraph 39-12(7) of the Enforcement Order 16 Subparagraph 66-5(2)(i) of the STML 17 Paragraph 39-12(8) of the Enforcement Order 18 Paragraphs 66-5(3) and (4) of the STML 19 Paragraph 66-5(5) of the STML: In a case prescribed by cabinet order as a case i n which a corporation has conducted a transaction with a foreign a f f i l i a t e d person of said corporation through another person (excluding another foreign a f f i l i a t e d person of said corporation or a domestic corporation which has a special r e l a t i o n s h i p with said foreign a f f i l i a t e d person: hereinafter refer r e d to as " u n a f f i l i a t e d person"), the transaction between said corporation and said u n a f f i l i a t e d person s h a l l be deemed to be a foreign a f f i l i a t e d transaction and the provisions of paragraph (1) s h a l l be applied accordingly. 20 Paragraph 39-12(9) of the Enforcement Order 21 Supra, note 5, at para. 38 22 Paragraph 39-12(10) of the Enforcement Order 23 Supra. note 5, at 38 24 Paragraph 66-5(6) of the STML 25 Paragraph 39-12(11) of the Enforcement Order 26 Section 982 of the U.S. IRC 162 27 Paragraph 66-5(7) of the STML: When i t i s necessary i n connection with an audit concerning the transactions between a corporation and a foreign a f f i l i a t e d person of said corporation, o f f i c i a l s of the National Tax Administration or o f f i c i a l s of the d i s t r i c t taxation o f f i c e and regional taxation bureau having j u r i s d i c t i o n over the place of tax payment of a corporation s h a l l be able to request of said corporation the disclosure or production of records or books, or copies thereof, over which sai d foreign a f f i l i a t e d person maintains custody. In t h i s case, i f said corporation i s requested to dis c l o s e or produce hereunder, i t s h a l l endeavor to obtain said records and books, or copies thereof. 28 A r t i c l e 153 of the JCTL 29 Paragraph 66-5(7) of the STML 3 0 The s p e c i f i c items to be provided are as follows ( A r t i c l e 22-10 of Special Taxation Measures Law Enforcement Regulation): (a) the reasons for which the foreign corporation corresponds to a foreign a f f i l i a t e d person pertaining to the taxpayer corporation; (b) the amount of c a p i t a l of the foreign a f f i l i a t e d person as of the end of the business year of said taxpayer corporation and the contents of the p r i c i p a l business a c t i v i t i e s conducted by said foreign a f f i l i a t e d person; (c) the t o t a l amount of consideration which the taxpayer corporation received, by type of transaction, from i t s foreign a f f i l i a t e d corporation or the t o t a l amount of consideration which the taxpayer corporation paid, by type of transaction, to i t s foreign a f f i l i a t e d person during said business year; (d) other matters required for reference. 31 For example, i n the case of the Japan-U.S. Income Tax Conven-t i o n , corresponding adjustments have been made based on Paragraph 25(2) of the Convention. 32 Supra. note 5, at 44 33 Supra, note 5, at 44 34 Paragraph 7(2) of the Law f o r Enforcement of Tax Treaties 35 Subparagraph 2 3 ( 2 ) ( i i i ) of the General Law of National Taxes, Paragraph 6(4) of the Cabinet Order Implementing General Law of National Taxes and A r t i c l e 7 of the Law for Enforcement of Tax Treaties 3 6 Supra. note 5, at 45 37 Supra. note 3, at para. 18 163 38 Supra. note 3, at para. 19 39 Supra, note 3, at para. 20 40 Supra. note 3, at para. 21 41 Supra, note 3, at para. 22 42 Supra. note 3, at para. 22 43 Supra. note 3, at para. 22 44 A "genuine" comparable uncontrolled p r i c e i s , for example, the amount of consideration of the good, which i s the same as that involved i n the foreign a f f i l i a t e d transaction, sold i n the arm's length transaction between the taxpayer i n question and an unrelated party under the same circumstances. 45 A "so-called" comparable uncontrolled p r i c e i s , f o r example, the amount of consideration of the good, which i s s i m i l a r to that involved i n the foreign a f f i l i a t e d transaction, sold i n the arm's length transaction between unrelated p a r t i e s under the d i f f e r e n t circumstances. Accordingly, the differences should be adjustable on some reasonable basis f o r such a p r i c e to be used as a comparable uncontrolled p r i c e . 46 Supra. note 3, at para. 24 47 Supra. note 3, at para. 28 48 Supra. note 3, at para. 28 49 Transfer P r i c i n g and Multinational Enterprises. Report of the OECD Committee on F i s c a l A f f a i r s (1979), at para. 15 and 37 50 Supra. note 3, at para. 29 51 Supra. note 3, at para. 30 52 A r t i c l e 66-5 of the STML and A r t i c l e 39-12 of the Enforcement Order often use the "foreign a f f i l i a t e d person", however, t h i s foreign a f f i l i a t e d "person" means a foreign a f f i l i a t e d "corporation". (Paragraph 66-5(1) of the STML) 53 Since subsection 69(1) of the Income Tax Act applies to a domestic transaction, the amount of consideration i n such a domestic non-arm's length transaction s h a l l be deemed to be the f a i r market value. However, as stated i n page 14, Revenue Canada uses the same theory and p r i n c i p l e of transfer p r i c i n g to determine the f a i r market value as subsections (2) and (3) . 164 54 The Japanese Corporation Tax Law has the anti-avoidance provision aimed at transfer p r i c i n g manipulation by a "family c o r p o r a t i o n " . ( A r t i c l e 132 of the CTL) However, the ap p l i c a t i o n of t h i s provision i s considerably r e s t r i c t e d , along with tax authority's burden of proof, t h i s provision i s useless at administrative l e v e l s . 55 Subparagraph 39-12(1)(iii) of the Enforcement Order 56 A r t i c l e 84 of the Constitution of Japan provides: No new taxes s h a l l be imposed or e x i s t i n g ones modified except by law or under such conditions as law may prescribe. 165 CHAPTER IV CONCLUSION 1. INTRODUCTION As discussed i n the preceding chapters, the present i n t e r n a t i o n a l transfer p r i c i n g taxation system and i t s enforcement present a number of d i f f i c u l t problems to both tax aut h o r i t i e s and MNCs. Although, i n actual enforcement, most of serious double taxation cases have generally been successfully avoided, some of the cases were s e t t l e d at the s a c r i f i c e of the MNCs which could not but accept the double taxation or the cof f e r s of countries whose system and administration have d e f i c i e n c i e s . However, i t might not be possible or appropriate to change the present transfer p r i c i n g taxation l e g i s l a t i o n d r a s t i c a l l y . Since the present l e g i s l a t i o n , at lea s t f o r the developed countries, i s f a i r l y reasonable f o r the purpose of protecting the int e r e s t s of both tax aut h o r i t i e s and taxpayers, further d r a s t i c changes, even i f t e c h n i c a l l y or p o l i t i c a l l y possible, may not be able to maintain the balance of those i n t e r e s t s . Therefore, future possible and p r a c t i c a l improvements would depend upon e f f o r t s at the l e v e l s of the tax administrators and taxpayers. In t h i s chapter I w i l l discuss possible improvements i n 166 i n t e r n a t i o n a l t r a n s f e r p r i c i n g taxation system and key considera-tions to be given, based on mainly the present situations of Canada and Japan, and with reference to two OECD reports. 2. POSSIBLE IMPROVEMENTS More d e t a i l e d guideline of the arm's length p r i n c i p l e As mentioned i n Chapter I I , the present Canadian Income Tax Act provides only a general rule of tran s f e r p r i c i n g taxation. U n t i l IC 87-2 was issued, taxpayers and tax p r a c t i t i o n e r s have been t r y i n g to deduce the in t e r n a l guidelines of Revenue Canada from actual cases and other information. The long-awaited information c i r c u l a r explains the arm's length p r i n c i p l e i n a r e l a t i v e l y simple manner i n comparison with the U.S. IRC Regulation. I f the Canadian taxpayer can use any method to calcul a t e the reasonable arm's length p r i c e and burden of proof i s l a i d on Revenue Canada, the present approach might be appropriate. However, under the Income Tax Act, the burden of proof to e s t a b l i s h the reasonableness of the tran s f e r prices i s l a i d on the taxpayers, although the taxpayer i s l e g a l l y e n t i t l e d to use any p r i c i n g method, providing that i t r e s u l t s i n the reasonable arm's length p r i c e . Since there i s l i t t l e j u r i s p r u -dence i n t h i s area, i t i s very d i f f i c u l t f or the taxpayers to f i x the t r a n s f e r p r i c e s with certainty. On the contrary, at present, despite the deficiency, f i e l d audit o f f i c a l s of Revenue Canada do not seem to f e e l much inconvenience and d i f f i c u l t y . 167 However, once Revenue Canada recommends the use of p a r t i c u l a r methods i n IC 87-2, i t should provide more detailed guidelines on the use of the p r i c i n g method, even though the determination of the arm's length p r i c e i s a question of fact and i t would be d i f f i c u l t to provide general guidelines which meet every case such as i n determining c a p i t a l gains or business incomes. I t seems to be appropriate and possible to provide detailed explanation, through the use of a number of examples as i n the U.S. IRC Regulation. Although U.S. taxpayers also complain that the present IRC Regulation i s not d e t a i l e d enough, detailed guidelines by Revenue Canada using examples may reduce unnecessary arguments and augment tax compliance. I t should be noted that Revenue Canada has already set out s p e c i f i c p r i c i n g guidelines for the pharmaceutical industry and i s preparing to do the same fo r other i n d u s t r i e s . 1 On the other hand, under the new Japanese system, f a i r l y concrete c a l c u l a t i o n methods of an arm's length p r i c e are written i n the law and d e t a i l e d interpretating rules are stated i n the Enforcement Order. Further d e t a i l s of i n t e r p r e t a t i o n w i l l be provided whenever necessary i n the form of a "Directive of the NTA Commissioner". "Advance Ruling" and "Confirmation System" Since 1970, Revenue Canada has been providing "advance r u l i n g s " which enable the taxpayer to know what tax consequences 168 would a r i s e from a business transaction which the taxpayer 2 proposes to carry out. The advance r u l i n g i s an administrative 3 procedure and there i s no l e g i s l a t i v e basis f o r i t . The procedures to be taken are set out i n the Information C i r c u l a r 70-6R. The objectives are to provide certainty i n respect of the proposed business transactions and to promote voluntary 4 compliance and uniformity. The taxpayer's a p p l i c a t i o n for advance ru l i n g s i s only accepted i f there i s a bona f i d e business purpose for the 5 proposed transaction. Therefore, i f the tax planning motive i s dominant i n the proposed transaction, Revenue Canada w i l l refuse the a p p l i c a t i o n . 6 Although, the number of applications and advance r u l i n g s issued i s s i g n i f i c a n t and requires the work of a number of r u l i n g o f f i c e r s , according to Revenue Canada, tax p r a c t i t i o n e r s complain that ru l i n g s are only obtainable i n the c l e a r e s t of circumstances i n accordance with an overly s t r i c t i n t e r p r e t a t i o n of the law, and that there i s a reluctance to grant rulings i n contentious areas. I t i s also recognized that the procedure i s time-consuming and there are delays i n processing the r u l i n g a p p l i c a t i o n . 7 Although the determination of an arm's length p r i c e i n a t r a n s f e r p r i c i n g case i s a question of f a c t and might not be sui t a b l e f o r advance rul i n g s , the advance r u l i n g procedure seems to be a useful way to make up for the deficiency i n the present guideline of the transfer p r i c i n g taxation system. In addition, even though the determination of the arm's length p r i c e i s case-oriented, i t i s expected that the p u b l i c a t i o n of actual rulings 169 concerning tr a n s f e r p r i c i n g cases would present convenient guidelines f o r taxpayers. However, Revenue Canada seems not to be so optimi s t i c . According to Revenue Canada's experience, MNCs which make r u l i n g applications do not always make the intra-group transaction s o l e l y f o r bona f i d e business purposes and the r u l i n g procedures are abused, or not used i n a proper manner by tax p r a c t i t i o n e r s . For example, the tax p r a c t i t i o n e r s often, d e l i b e r a t e l y or not, f a i l to di s c l o s e a l l the facts, the r e a l purpose of the transac-t i o n , and the reason and basis for a requested r u l i n g . They may f a i l to provide a l l the relevant documentation, or request many ruli n g s f o r no apparent reason, or they may bury material facts i n voluminous documentation without s p e c i f i c a l l y i d e n t i f y i n g g them. As to the publication of ruli n g s , Revenue Canada has published r u l i n g s i n the past. But the r u l i n g on the tax implication of a p a r t i c u l a r case tends to become obsolete due to changes i n the tax law or i t s interpretation, and i t i s d i f f i c u l t to revise the facts contained i n a r u l i n g to the changed law. Therefore Revenue Canada decided not to undertake further 9 p u b l i c a t i o n of the ru l i n g s . Although the above-mentioned abuses by the tax p r a c t i t i o n e r might be exaggerated to some extent, besides Revenue Canada's trouble, MNCs might not be able to wait the r u l i n g be issued where the proposed transaction required to be urgently made. Considering the above-mentioned present s i t u a t i o n of advance r u l i n g procedure, one should not over-estimate the function of the r u l i n g . However, as long as Revenue Canada's guidelines for 170 the arm's length p r i n c i p l e remains at present l e v e l s , advance ru l i n g s w i l l be one of few measures avail a b l e to a l l e v i a t e the uncertainty of i t s applic a t i o n . In Japan, the NTA Commissioner's S p e c i f i c D i r e c t i v e might be equivalent to Revenue Canada's advance r u l i n g . A S p e c i f i c D i r e c t i v e i s NTA's o f f i c i a l i n t e r p r e t a t i o n of tax laws i n a p a r t i c u l a r case. Accordingly, i t becomes the precedent and binds the i n t e r p r e t a t i o n and assessment by NTA o f f i c i a l s i n other s i m i l a r cases. However, there are constraints due to li m i t e d human resources. For example, i n the case of the Corporation Tax Law, only some 30 o f f i c i a l s i n the r u l i n g section i n the head o f f i c e deal with the procedure as part of t h e i r work. I t i s also very time-consuming. For example, an ordinary case requires the approval from at l e a s t 10 o f f i c i a l s before a S p e c i f i c Directive can be issued and published. Thus, the number of S p e c i f i c Directives issued per annum i s very few i n comparison with Revenue Canada's advance r u l i n g s . In addition, the taxpayer i n Japan who makes an ap p l i c a t i o n for a S p e c i f i c D i r e c t i v e would be required to provide the d e t a i l e d information of the transaction. Therefore, the issuance of the Directives i n f a c t tends to be l i m i t e d to the "big cases", where the tax consequence are s i g n i f i c a n t . In most cases, where taxpayers want to know the i n t e r p r e t a t i o n of tax laws or tax consequences of a p a r t i c u l a r transaction, taxpayers use the Tax Counselors or ask other tax o f f i c i a l s informally. Opinions thus provided by the Tax Counselors or other tax o f f i c i a l s have no binding e f f e c t s . 171 Since Japanese tax p r a c t i t i o n e r s have not been aggressive i n arguing the i n t e r p r e t a t i o n of tax laws with the tax authority, there have so f a r been few complaints about the above-mentioned s i t u a t i o n . However, as stated i n Chapter I I I , 1 0 under the new t r a n s f e r p r i c i n g taxation system, the NTA i s going to introduce the "confirmation system". Under the confirmation system, a taxpayer would propose to the NTA the method of determining the arm's length p r i c e which he thinks i s most reasonable and the scope of the e s s e n t i a l information he i s w i l l i n g to provide. A f t e r undertaking in-depth studies of the proposal, i f the NTA finds the proposal reasonable, the NTA w i l l give the taxpayer a sort of confirmation. This should cause a considerable increase of workload to the NTA, and s i m i l a r problems experienced by Revenue Canada and Canadian tax p r a c t i t i o n e r s might be expected. However, the objectives of the confirmation system, that i s , to prevent the occurrence of t r a n s f e r p r i c i n g taxation cases and to eliminate possible uncertainties as much as possible i n i n t e r n a t i o n a l transactions are quite appropriate, therefore i t s e f f e c t i v e and e f f i c i e n t enforcement must be found. Safe Haven As stated i n Chapter I I , 1 1 i t i s expected that safe haven rules w i l l reduce the uncertainty of taxpayer and unnecessary arguments between the tax a u t h o r i t i e s and taxpayers. But i t has a number of problems, such as an a r b i t r a r i n e s s or complexity i n a p p l i c a t i o n . Furthermore where one tax authority could succeed i n s e t t i n g out c e r t a i n safe haven ranges, unless the relevant 172 foreign tax authority accepts such rules, f o r the taxpayers who would make an international intra-group transaction, the danger of double taxation would s t i l l remain. An agreement on the safe haven range i n a p a r t i c u l a r industry between the tax authorities would usually need a j o i n t industry study as prerequisite. At the very l e a s t , t h i s means that the tax authority which i s going to set out the safe haven range fo r the transaction by a p a r t i c u l a r taxpayer or industry should provide detailed information about the taxpayer or industry to the relevant foreign tax a u t h o r i t i e s i n advance. Therefore i t does not seem l i k e l y that the area i n which safe haven rules can be set out w i l l increase f o r the near future. The NTA's confirmation system also aims to set out safe haven rules. To protect the taxpayer from double taxation, the NTA r e a l i z e s that i t i s desirable to secure i n advance the relevant treaty partners' informal concurrence or t a c i t understanding of 12 the proposal. As stated i n Chapter III , since i t i s d i f f i c u l t to get even informal concurrence from the foreign tax a u t h o r i t i e s , i t would not be p r a c t i c a l for the NTA to seek formal acceptance. Although the nature or e f f e c t and s p e c i f i c procedures of the confirmation system are under consideration, the NTA would be i n a d i f f i c u l t s i t u a t i o n that i f the foreign tax authority makes adjustments on the t r a n s f e r prices i n taxpayer's intra-group transaction to which the NTA had already given the confirmation as the reasonable p r i c i n g method to calculate an 173 arm's length p r i c e , and the NTA and the foreign tax authority f a i l to agree on the corresponding adjustment i n the mutual agreement procedure. Even i f the adjustment made by the foreign tax authority i s not acceptable for the NTA, the taxpayer would request the NTA to make a corresponding adjustment or provide u n i l a t e r a l r e l i e f to a l l e v i a t e double taxation. In such a case whether or not the NTA i s obliged to make such a corresponding adjustment or other sort of r e l i e f would depend on the NTA's p o l i c y on t h i s matter. I f the NTA accepts such an obligation, the number of applications would increase and the NTA might be reluctant to give a confirmation to prevent revenue l o s s . From t h i s viewpoint, deliberate consideration should be given i n deciding the procedure and e f f e c t of the system. wTransaction - b v-transaction H approach 13 As stated i n Chapter II , Revenue Canada's transaction-by-transaction approach has been severely c r i t i c i z e d by taxpayers and tax p r a c t i t i o n e r s arguing that: (i) there i s no l e g a l authority for such an approach under the Income Tax Act, ( i i ) i n the case of a "package deal" which i s common i n i n t r a -group transactions of MNCs, i t i s often very complicated and sometimes impossible to i d e n t i f y the various items i n a deal as separate transfers and to evaluate and charge separately, and ( i i i ) what may seem unreasonable when viewed on a transaction-by-transaction basis may be quite reasonable i n r e l a t i o n to o v e r a l l 14 maximization of the p r o f i t s of the taxpayer. To conform to the 174 arm's length p r i n c i p l e , Revenue Canada should follow the approach taken by the IRS 1 5 and the OECD Report. 1 6 On the other hand, Revenue Canada understands that the present t r a n s f e r p r i c i n g taxation l e g i s l a t i o n provided i n section 69 of the Income Tax Act, unlike the U.S. Internal Revenue Code, does not provide for the r e a l l o c a t i o n of income between resident taxpayers and non-residents. Accordingly section 69 applies to each transaction between the various related p a r t i e s and not to the Canadian taxable income, return on sale, return on equity, or 17 other measurements of general p r o f i t a b i l i t y . Therefore, Revenue Canada could not accept the so-called "bottom l i n e " approach, 18 which enables a taxpayer to avoid the adjustment i n most cases. While i t might be true that a separate i d e n t i f i c a t i o n and valuation of various products and services w i l l not only f a c i l i t a t e the audit of international transactions but w i l l also 19 a s s i s t t h e i r negotiations to avoid double taxation, the s t r i c t a p p l i c a t i o n of a transaction-by-transaction approach would impose an i n t o l e r a b l e burden on MNCs and would d i s t o r t the f l e x i b i l i t y of sound economic a c t i v i t i e s by MNCs. However, i t seems that Revenue Canada w i l l not always intend to apply the transaction-by-transaction approach. I t s p o l i c y i s that i t w i l l analyze intra-company relationships on a transac-2 0 tion-by-transaction basis whenever possible, but i f not, i t w i l l analyze the p r i c i n g of a p a r t i c u l a r product during the year, or focus on a p a r t i c u l a r product l i n e and so on. IC 87-2 states: I f the above [ i . e . transaction-by-transaction] approach i s not p r a c t i c a l or proves u n r e a l i s t i c i n terms of the 175 manner i n which the p a r t i c u l a r industry conducts i t s business, then the taxpayer should be prepared to provide, i n a comprehensive statement of intercompany p r i c i n g p o l i c y , the basis on which transfer prices are established world-wide. 21 Therefore, i n practice, discrepancies i n approach between Revenue Canada and the taxpayers might not be so serious. As stated e a r l i e r , the provisions of the Japanese transfer p r i c i n g taxation l e g i s l a t i o n , paragraph 66-5(1) of the Special Taxation Measures Law, i s s i m i l a r to section 69 of the Canadian Income Tax Act, rather than section 482 of the U.S. Internal Revenue Code. Accordingly, the same kind of arguments which have been made between Revenue Canada and Canadian taxpayers might be applicable to the Japanese l e g i s l a t i o n . At t h i s point i n time, the NTA has not yet revealed i t s approach regarding package deals, s e t - o f f or other s i t u a t i o n s where separate evaluation of various items i n a transaction might not be reasonable or impossible. However, one should consider the NTA's basic p r i n c i p l e s mentioned i n Chapter I I I , that i s , to n e u t r a l i z e as much as possible the e f f e c t s of transfer p r i c i n g taxation on legitimate economic decisions and a c t i v i t i e s , and to secure a f a i r and reasonable assessment which helps ensure long-term voluntary compliance of taxpayers, and to minimize excessive and c o s t l y administrative burdens on taxpayers. Although the evaluation of an arm's length p r i c e should be made on a transaction-by-transaction basis, the NTA's attitude can be 176 expected more f l e x i b l e and generous f o r the "bottom l i n e " approach. Cross-check and reasonable allowance of the arm's length p r i c e As the OECD Report recommends, i t i s quite reasonable and desirable that the tax auth o r i t i e s should v e r i f y the reasonable-ness of the p r o v i s i o n a l l y acceptable prices which are calculated as the arm's length prices based on a p a r t i c u l a r method by another p r i c i n g method which i s also available, even though less 22 reasonable to apply. In other words, except the case where a reasonable arm's length p r i c e can be c l e a r l y i d e n t i f i e d , f or example where the genuine comparable uncontrolled p r i c e i s availab l e , i t may be necessary to make additi o n a l calculations and computations to cross-check the arm's length p r i c e derived, by so-called "other methods". Although those methods are not useful i n fin d i n g an arm's length p r i c e i n i s o l a t i o n , they can be very useful as measures to v e r i f y the p r i c e derived by one of the 23 three basic methods. This administrative practice should f a c i l i t a t e the f a i r and reasonable enforcement of the transfer p r i c i n g taxation system and protect the taxpayers against unnecessary adjustments. Furthermore, cross-checks using various p r i c i n g methods would indicate a reasonable range or allowance of the arm's length p r i c e . As the OECD Report states, i n most of actual cases, the transactions within MNEs may not be d i r e c t l y comparable with those which take place between 177 independent enterprises so that allowances have to be made i n comparing t h e i r transfer prices with the prices payable between independent enterprises. 24 Where differences e x i s t between the transfer p r i c e and a compar-able p r i c e , such difference should be quantified and adjusted. However, unquantifiable or unadjustable differences might remain, and therefore a reasonable allowance should be granted. Revenue Canada has not c l e a r l y expressed i t s attitude on t h i s issue yet. But, contrary to a few c y n i c a l taxpayers' expectations, Revenue Canada has been making genuine e f f o r t s i n ca l c u l a t i n g the arm's length p r i c e prudently. Revenue Canada seems to understand that a reasonable arm's length p r i c e may not be an ascertainable amount, but rather a reasonable approxima-t i o n . A f t e r the c a l c u l a t i n g the provi s i o n a l arm's length price, i t s f i e l d auditors usually cross-check the r e s u l t of t h e i r compu-tations with other p r i c i n g methods or make further functional analysis, or re-examine the comparability of the unrelated trans-action they referenced. 25 As stated i n Chapter I I I , the NTA also f u l l y r e a l i z e s the necessity and usefulness of cross-checking with other p r i c i n g methods and the granting of a reasonable allowance to the arm's length p r i c e . The NTA plans to adopt such considerations as operating guidelines when enforcing the tran s f e r p r i c i n g taxation system. Mutual cooperation between tax a u t h o r i t i e s The OECD 1984 Report recommends that the tax authorities 178 augment mutual cooperation with t h e i r counterparts i n foreign countries through the exchange of information and communicate with each other i n transfer p r i c i n g matters i n as f l e x i b l e a manner as possible, whether i n writing, by telephone, by face to face or round the table discussion, whichever i s most suitable. 26 In t h i s context, i t can be said that the r e l a t i o n s h i p between Revenue Canada and the IRS exemplifies the OECD recommen-dations. In the area of information exchange, both tax authorities have engaged successfully i n "automatic" and " s p e c i f i c " exchanges of information based on A r t i c l e XXVII of the Canada-U.S. Income 27 Tax Convention. In addition, they have started since 1977 a 28 simultaneous examination ( c i v i l ) program. Under t h i s program, the taxpayers which are usually large MNCs with operations i n both countries and use tax havens as a part of t h e i r a c t i v i t i e s 29 have been selected. Owing to various factors such as the d o l l a r volume of world-wide sales and assets and existence of i d e n t i c a l tax years f o r both countries, which should be taken into account 30 . . i n s e l e c t i n g the case, and l i m i t e d human resources, the number of actual examination per annum i s s t i l l l i m i t e d . However, t h i s program i s not only useful for e f f e c t i v e and economical audits but also provides benefits to taxpayers. For example, by encouraging the sharing of fresh information and ensuring consistent adjustments i n both countries, possible double 31 taxation s i t u a t i o n s can be avoided and taxpayers' burden to provide information, e s p e c i a l l y foreign-based information to the 179 tax a u t h o r i t i e s are minimized. In connection with the simultaneous examination program, Revenue Canada and the IRS have commenced a " j o i n t industry studies" program. The main objectives of the program are to obtain comprehensive data on world-wide industry practices and operating pattern of various 32 major ind u s t r i e s . ( Revenue Canada has industry studies arrangements with several countries at present, and the forest products, grain, o i l and drug industries have been studied i n 33 those programs.) Information obtained i n those studies would help more e f f e c t i v e review of tax returns of MNCs by i d e n t i f y i n g industry's usage of tax havens and se l e c t i o n of potential 34 candidates f o r simultaneous examination. Furthermore, the "spontaneous" exchange of information has also developed between both two auth o r i t i e s both qu a n t i t a t i v e l y and q u a l i t a t i v e l y . In the area of the mutual agreement procedure, Revenue Canada and the IRS have been successful i n communicating with each other. At present, they conduct face-to-face meetings on a quarterly basis, and they always deal constantly with more than 35 50 cases per annum. MNCs have been concerned about "broad brush" or "package deal" approach between tax au t h o r i t i e s , that i s , mutual agreement procedures are s e t t l e d , not on the merits of each i n d i v i d u a l case, but on the basis of a balance of int e r e s t between the competent aut h o r i t i e s themselves. As the OECD 1984 Report states, mutual agreement procedure cases "should each be s e t t l e d on t h e i r own in d i v i d u a l merits and not by reference to 3 6 any balance of the re s u l t s i n other cases." However, i t can be 180 said that the existence of a number of other cases and the importance of keeping good r e l a t i o n s sometimes make the competent au t h o r i t i e s reach an agreement i n a case where the agreement would reduce the revenue to i t s c o f f e r s and be accordingly, "emotionally" reluctant to accept for the tax authority. A c t u a l l y most of the double taxation cases which were discussed i n mutual agreement procedures have been s e t t l e d . On the other hand, although Japan has had tax t r e a t i e s with various countries and most of them had the provision f o r exchange of information, the NTA has not been making e f f e c t i v e use of information exchanges. Only a f t e r becoming a member of the PATA, did the NTA became r e a l i z e d the importance and usefulness of information exchanges. The Japanese taxpayers, such as the MNCs who thought they could implement any international tax avoidance or evasion scheme due to the NTA's long-time i n a b i l i t y to obtain foreign-based information, were surprised to receive telexes from t h e i r overseas branches or subsidiaries that Revenue Canada or the IRS investigated t h e i r o f f i c e s and that NTA o f f i c i a l s possessed the information obtained from the foreign tax a u t h o r i t i e s . The number of cases of information provided by foreign tax a u t h o r i t i e s to the NTA doubled from 1980 to 1984 and the number of cases of information provided by the NTA to foreign tax a u t h o r i t i e s increased three times for the same period. The NTA has been successful i n c u l t i v a t i n g the r e a l a t i o n -ships with the PATA member countries, i . e . Canada, the U.S. and A u s t r a l i a . The NTA has commenced semi-annual high-level face-to-181 face meetings with the IRS and also concluded an agreement on simultaneous examination with the IRS i n 1985. The NTA has also 37 p a r t i c i p a t e d with PATA members i n the industry-wide studies. I t can be said that due to these relationships, the p o s s i b i l i t y of unrelievable double taxation has been considerably reduced. However, i t should be recognized that the NTA's relat i o n s h i p with i t s foreign counterparts i s s t i l l i n the stage of infancy i n comparison with the re l a t i o n s h i p between Revenue Canada and the IRS. Since cooperation and mutual understanding with foreign tax aut h o r i t i e s i s of utmost importance for the f a i r and e f f e c t i v e enforcement of the new Japanese transfer p r i c i n g taxation system, above a l l , the confirmation system, the NTA should strengthen i t s r e l a t i o n s h i p with not only PATA members but also with other tax aut h o r i t i e s as soon as possible. Close monitoring by headquarters There has been a complaint that i n the U.S., due to the lack of appropriate monitoring and supervision of section 482 a l l o c a -t i o n cases by the headquarter i n Washington, D.C., f i e l d auditors make unreasonable or inconsistent adjustments on the transfer prices of MNCs. Since irrevocable steps have been taken at the d i s t r i c t o f f i c e l e v e l , such adjustments cause prolonged and co s t l y mutual agreement proceedings when s e t t l i n g cases. I t can be said that the e a r l i e r the competent authority considerations are taken, the easier and fas t e r double taxation case can be resolved. Therefore, i t might be reasonable to require that whenever a f i e l d auditor plans to make a transfer p r i c i n g 182 adjustment on an international transaction by a MNC, he should make a r e f e r r a l to the headquarter. In cases where such adjustments would r e s u l t i n double taxation f o r the MNC, headquarters should c l o s e l y monitor the assessment, and i f necessary take over at an early stage. 38 As stated i n Chapter I I I , the NTA f u l l y r e a l i z e s the necessity and importance of close monitoring and i s planning to es t a b l i s h the Special Staff for International Audits. This o f f i c e , along with the O f f i c e of International' Operations, w i l l s t r i c t l y control the assessment made by f i e l d auditors i n the 39 d i s t r i c t taxation o f f i c e s and regional taxation bureaus. In Revenue Canada, the industry studies section i n the head o f f i c e i s i n charge of the enforcement of tran s f e r p r i c i n g taxation, and some sorts of guidance and supervision seem to have been adequately provided i n some areas by that section to f i e l d auditors i n d i s t r i c t o f f i c e s . Although such monitoring may be seen as uneconomical for audits, i t would secure reasonable and consistent enforcement of tra n s f e r p r i c i n g taxation which should help protect MNCs from double taxation and reduce unnecessary mutual agreement procedure cases. S e l f d i s c i p l i n e and documentation by MNCs As a f i n a l possible improvement, i t should be emphasized that a MNC should make every e f f o r t to conform to the arm's length p r i n c i p l e . 183 In Canada, as stated before, under the Income Tax Act, taxpayers can adopt any p r i c i n g method. However, i t i s strongly recommended that Canadian taxpayers should follow the p r i c i n g methods provided i n IC 87-2, since those basic methods are usually not only the easiest and most p r a c t i c a l but i n mutual agreement procedures those methods are also recognized as important c r i t e r i a when reaching an agreement among the competent au t h o r i t i e s From the experiences i n the U.S., however, i n practice, those basic methods have often been proved impractical. I t might be proved to be more p r a c t i c a l to base on a taxpayer's own p r i c i n g method, since a taxpayer cannot always apply professional functional analysis or obtain information such as the p r o f i t mark-up of i t s competitors. In such cases, i t i s also strongly recommended that a taxpayer record h i s transactions as p r e c i s e l y as possible with regard to the s i t u a t i o n , and whenever he i s required, provide a l l the information of which he has custody to Revenue Canada. Contrary to the tax p r a c t i t i o n e r s ' expectation, Revenue Canada i s not so merciless when c o l l e c t i n g money from the taxpayers. Rather, i t s f i e l d auditors are trained not to be concerned with small percentage differences and to accept the taxpayer's p r i c i n g arrangements as long as the arrangement has been reasonably and consistently operated i n comparable dealings with independent par t i e s as well as within the MNC and can be 40 evidenced by s u f f i c i e n t documents. I t should be noted that the necessity and importance of appropriate documentation are also 41 recognized by the chartered accountants. 184 In Japan, since f a i r l y concrete p r i c i n g methods are provided i n the "law" and cabinet order, i n other words, l e g a l l y authorized, taxpayers are required to use the s p e c i f i c methods prescribed. However, the NTA r e a l i z e s the d i f f i c u l t i e s of ac t u a l l y applying of those methods. Accordingly, as long as taxpayers have no intention of avoiding or evading tax and have been cooperative with the NTA during an audit, they usually do not have to worry so much about adjustments. Furthermore, considering the presumption provision, taxpayers are expected to provide a l l necessary information required by the tax o f f i c i a l s . 3 . KEY CONSIDERATIONS TO BE GIVEN Dishonest MNC vs. honest MNC Most of the transfer p r i c i n g taxation l e g i s l a t i o n applies whether or not the taxpayer intends to avoid or evade tax. Since, even MNCs themselves cannot always f i x the tran s f e r prices i n t h e i r intra-group transactions to conform to the arm's length p r i n c i p l e which are accepted by tax au t h o r i t i e s , MNCs have always complained that tax treatments such as the burden of proof against "honest" taxpayers who happened to f a i l to conform to the arm's length p r i n c i p l e are too harsh. The MNCs argue that those taxpayers should be treated d i f f e r e n t l y from dishonest taxpayers. On the other hand, there i s firm prejudice among tax administrators that MNCs always have the v i c i o u s intention to 185 save tax. The MNCs are thought to avoid or evade tax whenever i t seems possible to escape the eyes of the tax a u t h o r i t i e s . However, as the OECD Report suggests, " i t should not be assumed that the p r i c e a c t u a l l y charged within an MNC w i l l never be an 4 3 arm's length p r i c e . " I t i s a question of f a c t and the difference between "dishonest" taxpayers and "honest" taxpayers i s a hard one to make. In other words, dis t i n g u i s h i n g between the i l l e g a l tax avoidance or evasion and legitimate tax saving i s d i f f i c u l t . R e a l i z i n g that harsh tax treatments against "honest" MNCs in a p a r t i c u l a r country may eventually r e s u l t i n the reduction or withdrawal of business a c t i v i t i e s of the MNC from that country, and even though i t might be inappropriate or impossible to apply discriminative treatment i n accordance with the intentions of the of a MNC, i t might be possible to discriminate the dishonest taxpayers from the honest taxpayers at administrative l e v e l s . At the very l e a s t , more prudent consideration should be given during the course of the adjustment on the transfer p r i c e i f the MNC can e s t a b l i s h that i t had no intention to avoid or evade tax. In other words, i f the MNC can e s t a b l i s h by documents or other evidence that i t made every e f f o r t to conform to the arm's length p r i n c i p l e when f i x i n g intra-group p r i c i n g arrangements. Impact of tax revolution i n the U.S. Mr. Ward states: As most of us w i l l have observed, natural laws of physics indicate that water has a tendency to flow from places of higher l e v e l to those which are lower. Tax administrators have also observed a natural law of i n t e r n a t i o n a l taxation - the p r o f i t seems to flow 186 n a t u r a l l y from those countries where higher taxes are imposed to those imposing lower l e v e l s of taxation. 44 Tax a u t h o r i t i e s i n developed countries have been t r y i n g to tackle the inte r n a t i o n a l tax avoidance or evasion that follows t h i s natural law of international taxation, i . e . , the s h i f t i n g of the p r o f i t s to tax haven countries by tran s f e r p r i c i n g or other tax planning. In 1986, the U.S. Internal Revenue Code d r a s t i c a l l y changed: the tax rates f o r i n d i v i d u a l and corporate taxpayers were reduced to h a l f or les s than h a l f of those of Canada or Japan. At t h i s moment, i t can be said that the U.S. has become a "tax haven". Both Canada and Japan are a f r a i d that the U.S. tax revolution would provide more incentives f o r MNCs to s h i f t t h e i r p r o f i t s from related e n t i t i e s i n Canada or Japan to t h e i r U.S. e n t i t i e s , usually parent companies. In Canada, owing to i t s geographical l o c a t i o n and close r e l a t i o n s h i p s with the U.S. i n various aspects, some people concern that most of Canadian-based MNCs and wealthy individuals would go down to the south of border looking f o r more after-tax incomes. In the meantime, Japan i s seriously concerned that i n addition to those new U.S. tax incentives, the recent devastating strong "yen" and t r a d i t i o n a l l y strong U.S. interference i n the Japanese domestic po l i c e s , would make most of the large Japanese large companies s h i f t not only t h e i r p r o f i t s but also main a c t i v i t i e s to the U.S. At t h i s moment, a new tax b i l l which would reduce Japan's 187 tax rates on individ u a l s and corporate taxpayers to the almost same l e v e l as those of the U.S. i s being discussed i n the Japanese Diet. The Ministry of Finance of Canada i s also planning to propose a new tax b i l l which has a s i m i l a r e f f e c t as those of the U.S. and Japan. However, u n t i l the above-mentioned l e g i s l a t i v e proposals to equalize tax rates have been passed, Revenue Canada and the NTA w i l l have to prepare for the amount and number of transfer p r i c i n g manipulation s h i f t i n g p r o f i t s to the U.S. by taxpayers i n t h e i r respective j u r i s d i c t i o n s to s i g n i f i c a n t l y increase. E f f e c t of aggressive assessment by the IRS There have been rumors within the tax community i n Japan that the U.S. subsidiaries of some Japan-based MNCs are suff e r i n g from harsh assessments from the IRS using section 482 of the IRC. Those MNCs, without requesting competent authority procedures, have begun to manipulate t h e i r transfer p r i c i n g arrangements to s h i f t more p r o f i t s to t h e i r U.S. subsidiaries or permanent establishments i n order to s a t i s f y the IRS and a l l e v i a t e double taxation. Such rumors seem to have reasonable basis. I f t h e i r double taxation are j u r i d i c a l double taxation, the MNCs should have expected f u l l r e l i e f through the foreign tax c r e d i t system and i f t h e i r double taxation was not a l l e v i a t e d by the foreign tax c r e d i t system, since Japan did not have the tran s f e r p r i c i n g taxation l e g i s l a t i o n i n place and the MNCs could not expect much from mutual agreement procedures, i n some cases being assessed of double taxation was better than undertaking expensive and time-188 consuming court procedures. I t may not be appropriate to use the word "harsh" to describe the e f f e c t i v e and intensive assessment e f f o r t s of the IRS. One should recognize that the IRS i s the most advanced i n the area of international audit, and i t s organization and audit personnel are much better than those of the NTA or Revenue Canada i n terms of quantity, q u a l i t y and budget. As a c o r o l l a r y of the natural law of inte r n a t i o n a l taxation, "harsh" or aggressive assessments by the tax authority, i n p r i n c i p l e , should cause the MNCs s h i f t t h e i r p r o f i t s and a c t i v i t i e s to other countries which are more generous about the MNCs' aggressive tax planning, i . e . , such as tax haven countries, or escape to "underground economy". Contrary to t h i s p r i n c i p l e , the IRS•s intensive enforcement of the tran s f e r p r i c i n g taxation system seems to succeed i n keeping and r a i s i n g revenue by augmenting tax compliances of the MNCs. This exceptional phenomenon might be explained by the fact that the U.S. market i s by f a r the most important and p r o f i t a b l e market f o r most MNCs and even before the U.S. became a "tax haven", the IRC had a number of tempting loopholes. This creates a dilemma for both Revenue Canada and the NTA. Even i f i t i s important f o r them to strengthen t h e i r a b i l i t y enforcing t r a n s f e r p r i c i n g taxation system more e f f e c t i v e l y , they should be aware that t h e i r e f f o r t s w i l l reduce the revenue to t h e i r c o f f e r s i n the long run unless t h e i r tax laws become more advantageous for MNCs than those of the U.S. 189 4 . F I N A L R E M A R K S I t seems to me that we cannot expect better transfer p r i c i n g taxation l e g i s l a t i o n than those we have already. While i t i s important to provide detailed guidelines implementing the arm's length p r i n c i p l e to taxpayers, preferably i n the form of law, there should be l i m i t a t i o n s of i t s usefulness since an actual c a l c u l a t i o n of an arm's length p r i c e i s a question of fac t such as the argument about c a p i t a l gains or business income. A reasonable tr a n s f e r p r i c i n g taxation system would depend on prudent and f l e x i b l e enforcement by tax au t h o r i t i e s and s e l f -restrained manner i n f i x i n g t ransfer prices by the MNCs. As the NTA adopted as i t s basic p r i n c i p l e s , the following considerations should be s t r i c t l y observed by the tax au t h o r i t i e s : (a) To neutralize, as much as possible, the e f f e c t of the trans f e r p r i c i n g taxation on legitimate economic decisions and a c t i v i t i e s , and to secure a f a i r and reasonable assessment, which can ensure long-term voluntary compliance of taxpayers; (b) To minimize excessive and c o s t l y administrative burdens on taxpayers, while securing information e s s e n t i a l f o r f a i r , j u s t 4 5 and reasonable tax adjustments. Tax a u t h o r i t i e s should be careful not to k i l l the goose that bearing the golden eggs. 190 CHAPTER IV - FOOTNOTES 1 J . R. Robertson, A Revenue Canada Perspective on Interna-t i o n a l Taxation: Transfer P r i c i n g and Related Issues, Report  of the Proceedings of the Thirty-Fourth Tax Conference. Canadian Tax Foundation (1982), at 777 2 D. L. H. Davidson, Advance Ruling and Interpretation B u l l e t i n s , Report of the Proceedings of the T h i r t y - F i f t h Tax  Conference. Canadian Tax Foundation (1983), at 797 3 R. M. Beith, Advance Rulings: Administration and P r i n c i p l e s , Report of the Proceedings of the Thirty-Fourth Tax  Conference. Canadian Tax Foundation (1982), at 457 4 Ibid. 457 5 Ibid. 459 6 Ibid. 459 7 Supra. note 2, at 796 8 Supra, note 3, at 459 9 Supra. note 2, at 459 10 See page 148-149 11 See page 43-45 12 See page 148-149 13 See page 18 14 N. Boidman, Canada-US Intercompany (and other) Taxation Issues, Report of the Proceedings of the T h i r t y - F i f t h Tax  Conference. Canadian Tax Foundation (1983), at 323 15 The U.S. IRC Regulation 1.482-2(e)(1)(iv) 16 Transfer P r i c i n g and Multinational Enterprises, Report of the OECD Committee on F i s c a l A f f a i r s (1979), at para. 41 17 Supra. note 1, at 777 18 Supra, note 1, at 777 19 Revenue Canada, International Transfer P r i c i n g and other 191 International Transactions, Information C i r c u l a r 87-2 (1987), at para. 10 20 Supra, note 1, at 777 21 Supra, note 19, at para. 11 22 Supra, note 16, at para. 63 and 70 2 3 Supra, note 16, at para. 70 24 Supra. note 16, at para. 38 25 See page 152 26 Transfer P r i c i n g , Corresponding Adjustments and the Mutual Agreement Procedure, Transfer P r i c i n g and Multinational  Enterprises: Three Taxation Issues. Report of the OECD Committee on F i s c a l A f f a i r s (1984), at subpara. 116(iv) 27 J . A. Calderwood, A Revenue Canada Perspective on the Role and Method of Operation of the "Competent Authority", Report  of the Proceedings of the Th i r t y - S i x t h Tax Conference, Canadian Tax Foundation (1984), at 324 28 The simultaneous examination program on criminal cases has also started i n 1983. 29 Supra. note 27, at 325 30 Supra. note 27, at 325-326 31 P. E. Coates, The Role and Operation of the US Competent Authority, Report of the Proceedings of the T h i r t y - S i x t h Tax  Conference. Canadian Tax Foundation (1984), at 331-332 32 Supra, note 27, at 326 33 Supra. note 27, at 32 6 34 Supra, note 31, at 332 35 Supra. note 27, at 320 and 323 3 6 Supra, note 26, at para. 105 37 T. K i r i b u c h i , Japan's Transfer P r i c i n g Taxation: Introduction  and Enforcement. International Tax I n s t i t u t e Seminar on Transfer P r i c i n g Taxation (1986), at para. 22 38 See page 39 Supra. note 38, at para. 21 192 40 Supra, note 16, at para. 15 and 25 41 J . S. Peterson, International Transfer P r i c i n g : A Canadian Perspective, Report of the Proceedings of the T h i r t y - F i r s t  Tax Conference, Canadian Tax Foundation (1979), at 463-464 42 Supra. note 16, at para. 3 43 Supra, note 16, at para. 38 44 D. A. Ward, P r i c i n g and International Transactions, Report of  the Proceedings of Twenty-Eighth Tax Conference. Canadian Tax Foundation (1976), at 130-131 45 Supra. note 38, at para. 18 193 SELECTED BIBLIOGRAPHY Book Plasschaert, S. R. F., Transfer P r i c i n g and Multinational  Corporation: an overview of concepts, mechanisms and regulations, (U.K.: Saxon House, 1977) Reports IRS Could Better Protect U.S. Tax Interest i n Determining the  Income of Multinational Corporations. Report to the Chairman of the House Committee on Ways and Means (Washington,D.C.: The U.S. General Accouting O f f i c e , 1981) Model Double Taxation Convention on Income and on C a p i t a l . Report of the OECD Committee on F i s c a l A f f a i r s (Paris: OECD, 1977) Outline of Japanese Taxes 1986. Tax Bureau of the Ministry of Finance (Tokyo: P r i n t i n g Bureau, 1986) Transfer P r i c i n g and Multinational Enterprises. Report of the OECD Committee on F i s c a l A f f a i r s (Paris: OECD, 1979) Transfer P r i c i n g and Multinational Enterprises: Three Taxation  Issues. Report of the OECD Committee on F i s c a l A f f a i r s (Paris: OECD, 1984) A r t i c l e s and Monographs Baxter, G. C. and Konopka, R. A., Transfer P r i c i n g Across the Canada-US Border (1985), June CA Magazine 50 Beith, R. M., Advance Rulings: Administration and P r i n c i p l e s , Report of the Proceedings of the Thirty-Fourth Tax Conference (Canadian Tax Foundation, 1982) 456 194 Boidman, N., Canada-US Intercompany (and other) Taxation Issues, Report of the Proceedings of the T h i r t y - F i f t h Tax Conference (Canadian Tax Foundation, 1983) 312 Calderwood, J . A., A Revenue Canada Perspective on the Role and Method of Operation of the "Competent Authority", Report of the  Proceedings of the Thir t y - S i x t h Tax Conference (Canadian Tax Foundation, 1984) 315 Coates, P. E., The Role and Operation of the U.S. Competent Authority, Report of the Proceedings of the T h i r t y - S i x t h Tax  Conference (Canadian Tax Foundation, 1984) 327 Davidson, D. L. H., Advance Ruling and Interpretation B u l l e t i n s , Report of the Proceedings of the T h i r t y - F i f t h Tax Conference (Canadian Tax Foundation, 1983) 795 Harris, E. C., Intercompany Cross-border Transactions: A Growing Concern f o r Revenue Canada (1985), June CA Magazine 22 K i r i b u c h i , T., Japan's Transfer P r i c i n g Taxation: introduction and Enforcement (1986), International Tax I n s t i t u t e Seminar on  Transfer P r i c i n g Taxation Peterson, J . S., International Transfer P r i c i n g : A Canadian Perspective, Report of the Proceedings of the T h i r t y - F i r s t Tax  Conference (Canadian Tax Foundation, 1979) 451 Robertson, J . R., A Revenue Canada Perspective on International Taxation: Transfer P r i c i n g and Related Issues, Report of the  Proceedings of the Thirty-Fourth Tax Conference (Canadian Tax Foundation, 1982) 773 Tamaki, G. T. and Pound, R. W., Intercompany P r i c i n g : In Search of Guidelines (1974), 22 Canadian Tax Journal 460 T i l l i n g h a s t , D. R., An American View of International Inter-company P r i c i n g Problems, Report of the Proceedings of the  T h i r t y - F i r s t Tax Conference (Canadian Tax Foundation, 1979) 469 Ward, D. A., P r i c i n g and International Transactions, Report of  the Proceedings of the Twenty-Eighth Tax Conference (Canadian Tax Foundation, 1976) 130 195 A r t i c l e s and Monographs (Japanese Text) Kaneko, H., Arm's Length P r i n c i p l e i n Income Taxation i n the U.S.(1980-81), 724. 734 and 736 J u r i s t (Tokyo: Yuhikaku) #724-104, #734-56, #736-95 Odajima, S., Transfer P r i c i n g Taxation System (1986), Special  Issue - International Taxation (Tokyo: Kokusai-zeimu-kenkyukai) 24 Thomas, G. M., Recent Issues Concerning the Enforcement of Section 482 of the US Internal Revenue Code (1982), May -International Taxation (Tokyo: Kokusai-zeimu-kenkyukai) 20 Thomas, G. M. and Aramaki, K., Transfer P r i c i n g L e g i s l a t i o n (1986), Special Issue - International Taxation (Tokyo: Kokusai-zeimu-kenkyukai) 4 Cases Canadian General E l e c t r i c Company Ltd. v.Her Majesty The Queen (1982) D.T.C. 6232 Central Canada Forest Product Ltd. v. Minister of National  Revenue (1952) D.T.C. 359 Consolidated Bathurst Ltd. v. Her Majesty The Queen (1985) D.T.C. 5120 Dominion Bridge Co. Ltd. v. Her Majesty The Queen (1975) D.T.C. 5150 Her Majesty The Queen v. Saint John Shipbuilding & Dry Dock Co.  Ltd. (1980) D.T.C. 6272 Indalex Ltd. v. Her Majesty The Queen (1986) D.T.C. 6039 196 J. Hofert Ltd. v. Minister of National Revenue (1962) D.T.C. 50 Porta-Test System Ltd. v. Her Majesty The Queen (1980) D.T.C. 6046 Regina v. Redpath Industries Ltd. (1983) D.T.C. 5117 Spur O i l Ltd. v. Her Majesty The Queen (1981) D.T.C. 5168 Stubert Investments Ltd. v. Her Majesty The Queen (1984) D.T.C. 6305 Revenue Canada's Publication Interpretation B u l l e t i n IT-303 Know-How and Similar Payments to Non-Residents IT-468 Management or Administration Fees Paid to Non-Residents Information C i r c u l a r 70- 6R Advance Income Tax Rulings 71- 17R2 Requests for "Competent Authority" Consideration - Double Taxation Issues 76-12R2 Applicable Rate of Part XIII Tax on Amounts Paid or Credited to Persons i n Treaty Countries 87-2 International Transfer P r i c i n g and Other International Transactions 197 Internal Revenue Service's Publication Revenue Procedure 65-17 Technical Position and Procedure Governing the Adjustment of Accounts and the Transfer of Amounts as the Result of All o c a t i o n s of Income or Deductions made pursuant to section 482 of the Internal Revenue Code of 1954 70-18 Procedure Applicable to Resolving Issues Involving the A l l o c a t i o n of Income and Deductions Between Related E n t i t i e s under United States Income Tax Treaties Statutes and Regulations Canada The Income Tax Act S.C. 1970-71-72, c. 63, as amended The Income Tax Regulations C.R.C. 1978, c.945, as amended Japan The Cabinet Order Implementing the General Law of National Taxes 1962, Cabinet Order #135, as amended The Constitution of Japan 1946 The Corporation Tax Law 1965, Law #34, as amended The Corporation Tax Law Enforcement Order 1965, Cabinet Order #97, as amended The General Law of National Taxes 1962, Law #66, as amended The Income Tax Law 1965, Law #33, as amended 198 The Law f o r Enforcement of Tax Treaties 1969, Law #46, as amended The M i n i s t e r i a l Ordinance Implementing the Law for Enforcement of Tax Treaties 1969, Finance and Home A f f a i r s M i n i s t e r i a l Order #1, as amended The Special Taxation Measures Law 1957, Law #26, as amended The Special Taxation Measures Law Enforcement Order 1957, Cabinet Order #43, as amended The Special Taxation Measures Law Enforcement Regulations 1957, Finance M i n i s t e r i a l Order #15, as amended U.S. The Internal Revenue Code 1954, ch. 736, 68A Stat. 3, as amended The Income Tax Regulations 1954, as amended 

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