Canada Emergency Wage Subsidy: TPM-17 and Transfer Pricing Considerations – Taxation
On March 2, 2016, the Canada Revenue Agency (“CRA”) released Transfer Pricing Memorandum 17 “The Impact of Government Assistance on Transfer Pricing” (“TPM-17”). The MPT-17 describes the CRA guidelines on the treatment of government assistance and confirms the CRA policy: “When a cost-based transfer pricing method is used to determine the transfer pricing of goods, services or intangibles sold by a Canadian taxpayer to an arm’s length non-resident non-resident and the Canadian taxpayer receives government assistance, the cost base should not be reduced by the amount of assistance government received, unless there is reliable evidence that arm’s length parties would have done so given the specific facts and circumstances. “1 (emphasis added)
As an economist working in the Competent Authority Services Division (“CASD”) of the CRA at the time of this policy’s introduction, I saw first-hand the arguments raised by taxpayers in their claims. Mutual Agreement Procedure (“MAP”) or Prior Price Arrangement (“APA”) to attempt to support the “reliable evidence” exception. Now, in light of the pandemic and government subsidies provided by the government In Canada, TPM-17 policies are a hot topic in the Canadian transfer pricing landscape, as taxpayers determine how to approach the Canada Emergency Wage Subsidy (“CUSS”) for transfer pricing purposes.
How the TPM-17 works
Following the example of TPM-17, CanCo is a subsidiary of a multinational enterprise (“MNE”) and carries out research and development (“R&D”) activities on behalf of ForCo. CanCo spends $ 60 on R&D and $ 40 on overhead, for a total cost of $ 100. Based on the functional analysis of CanCo and ForCo, it is determined that the appropriate transfer pricing methodology is the Transactional Net Margin Method (“TNMM”) with a Profit Level Indicator (“PLI”) return on total costs. Based on a research of comparable companies, it is determined that CanCo is expected to earn 10% of its total costs, which would result in a total transfer price paid by ForCo of $ 110 and operating profit. $ 10 for Canco.
If a government grant of $ 10 were allocated to CanCo, ARC policy implies that the transfer price of ForCo remains at $ 110 and that the grant of $ 10 would directly offset CanCo’s R&D expenses, resulting in a profit of $ 20 operation for CanCo. This is the “gross cost” approach.
The alternative approach is that the $ 10 grant (or part of it) would be deducted from the R&D cost base before the transfer pricing, resulting in costs of $ 90 plus a 10% return, and a total transfer price of $ 99 paid by ForCo to CanCo and operating income of $ 9. In this net cost approach, CanCo shares all (or part of) government assistance with ForCo and reduces the amount payable to CanCo from $ 110 to $ 99 = $ 11.
Economic Considerations – How the Arm’s Length Parties Would Treat
The examples provided in MPT-17 present two very different views on how arm’s length parties would interact in these scenarios.
The following economic considerations would support CRA policy:
- Suppose that $ 100 in the cost base represents 10 hours of work at $ 10 per hour. These costs would be fully reimbursed by ForCo and the mark-up would apply to the full base costs. Compensating for costs and applying the mark-up to the reduced base of $ 90, even if 10 hours are worked, implies a lower return on the total of 10 hours worked.
- Again, CanCo incurs costs of $ 100 to perform the R&D activities it obtained from ForCo and, without a grant, would receive $ 110 for those activities from ForCo. If CanCo receives the government grant and it is deducted from the cost base, CanCo ends up losing $ 1 in profit due to the reduced cost base to be grossed up. At arm’s length, why would CanCo reduce its bottom line by accepting the grant if the end result is to offset the cost base with ForCo?
- From a comparability point of view, the accounting treatment of grants may not be consistent between the comparables identified. Unless the comparable has access to the same subsidy, under the same circumstances, it may be difficult to obtain an INP that reflects the net base price. This could result in a lower return per hours worked for CanCo compared to comparables.
The case for a net cost approach can be equally compelling, focusing more on competitiveness to secure the ForCo contract and the sponsor’s government’s intention to bring, keep or maintain jobs in its jurisdiction.
- As governments typically communicate when grant programs are established, including their terms and conditions, ForCo would be keenly aware that CanCo could leverage the grant to reduce its costs. Thus, ForCo could negotiate with CanCo to reduce the costs invoiced in order to obtain the R&D contract from ForCo. This scenario may apply if CanCo has many competitors bidding for the work of ForCo. However, if CanCo had a strategic advantage over its competitors, ForCo might have less bargaining power to secure part of the subsidy and succeed in retaining all of it.
- MNEs could also highlight the general intent of the government subsidy, including that it is aimed at attracting work to that jurisdiction as further evidence that the subsidy could result in a net cost approach. In this perspective, the government negotiates indirectly with ForCo, drawing it into its jurisdiction with an incentive that could be passed on by CanCo. Thus, the government, through the grant, shares the overall cost of the service provided by CanCo.
Ultimately, CRA policy begins with the gross cost approach and it is up to the MNE to demonstrate that arm’s length parties would share all or part of the grant.
COVID-19: Why is TPM-17 relevant today?
Since May 30, 2020, the Government of Canada has invested heavily to offset the devastating impact of the Covid-19 pandemic on various sectors of the Canadian economy through the SSUC. As of June 27, 2021, 3.8 million requests to the SSUC have been approved, including 5,940 claims for an amount greater than $ 1 million.2
Although the circumstances of the SSUC are different from the RD example in TPM-17, the underlying principle would remain the same: if any of the above companies that requested the SSUC were a financial services, the CRA would expect these companies to apply a gross cost approach to determining the transfer price. Otherwise, they would have to provide reliable evidence that arm’s length parties would share all or part of the grant with ForCo. However, since the policy behind SSUC is more akin to national unemployment insurance schemes, which are supposed to be temporary in nature, rather than a subsidy designed to attract work to Canada, it will be difficult for taxpayers to convince the CRA to withdraw from the gross cost approach in TPM-17.
In addition, as comparables may not have access to the same grant, it is difficult to understand the impact of the various relief measures put in place by governments and their impact on the financial data taken into account to determine performance. of CanCo under a TNMM. In a previous article, we discuss comparability differences in more detail, especially with regard to this situation.3
The ARC MPT-17 provides multinationals with clear direction as to how a CanCo should reflect any grants received to support research and development or manufacturing activities. However, TPM-17 also recognizes that, with reliable evidence, arm’s length parties could have behaved differently given specific facts and circumstances.
In any case, it is important that companies conduct a thorough analysis to support their approach, especially if the functional analysis leads them to determine that they have reliable evidence that the “gross cost” approach does not. not reflect their particular situation. When receiving government grants, including SSUC, taxpayers should always discuss their scenario with a transfer pricing expert before accepting the CRA’s preferred gross cost approach. This ensures that the facts and circumstances applicable to their situation reflect how arm’s length parties would treat such subsidies.
1 https://www.canada.ca/en/revenue-agency/services/tax/international-non-residents/information-been-moved/transfer-pricing/17-impact-government-assistance-on-transfer-pricing .html
3 Hill, D. and Hejazi, Dr J., Covid-19 just made transfer pricing more difficult, October 27, 2020. https://gowlingwlg.com/en/insights-resources/articles/2020/covid-19-just-made-transfer-pricing-more-difficult/
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