Canada: Impact Of Corporate Tax Rate Dynamics On The US-Canada Transfer Pricing Environment

As the world economy becomes increasingly globalised, pressure will continue to mount on multinational corporations to maximise overall profits.

The rise of low-cost nations such as China and India will require the more developed countries and their multinational corporations to become more cost competitive, both operationally and via the taxation policies/regimes they enact.¹ At the same time, the global economic crisis that began in 2008 has placed significant pressures on tax administrators to maximise tax revenues needed to eliminate sizable deficits that have occurred. The US will require a change of focus to stabilise the current budget deficit, which is currently at a record $1.4 Trillion. The weak economic growth within the G7 and US in particular, will create the incentive for nations to cover their deficits and debts by aggressively enforcing existing tax legislation. One area where multinationals can expect tax administrators to "tighten up" enforcement is through the aggressive application of transfer pricing rules. Transfer pricing involves the price that one member of a multinational firm charges another for goods, services or intangible property. Not surprisingly, transfer pricing has been identified as one of the most prominent international tax issues.

We have already seen evidence of this hardening of positions in the United States and Canada. On a per capita basis, the Canada Revenue Agency ("CRA") has more auditors than the US. In the US context, both words and action suggest stronger enforcement in the years to come. In a speech delivered by Internal Revenue Service ("IRS") Commissioner Doug Shulman to the Organisation for Economic Co-operation and Development ("OECD"), the Commissioner stated "As part of the President's budget, the IRS would be funded to hire nearly 800 new employees devoted specifically to international enforcement, such as agents, economists, lawyers and specialists." One can therefore expect that as the tax rate differential between Canada and the United States grows, companies are likely to become more aggressive, resulting in the IRS increasing audit activity of US companies with more, and better trained, international examiners well into the future.

While all G7 nations were adversely impacted by the global recession, Canada has performed remarkably well, incurring deficits that were lesser in both absolute size and intensity compared to its G7 counterparts. This has allowed Canada to continue reducing corporate tax rates and should result in Canada becoming a more business friendly nation, with less emphasis on corporate tax collection.

I. Current transfer pricing landscape and future outlook

Within the current Canada-US tax audit framework, Canada raises the majority of transfer pricing adjustments, with approximately 80 percent of total adjustments raised by the CRA and the IRS. This is not surprising given Canada is more of a subsidiary based economy. However, this is likely to change given the growing differences in corporate tax rates and that the deficit of the US is expected to remain high for many years. In 2011, the combined average federal and provincial tax rate is 27.64 percent, whereas the average US rate is 39.18 percent.

There is a strong likelihood that the US Treasury will take a more adversarial stance towards multinationals operating in the US due to budgetary considerations and changes in corporate tax rates in other G7 countries including Canada. The Canadian government has strategically lowered tax rates to increase Canada's competitiveness in attracting foreign direct investment relative to the US. Canada has been successful in doing so because of its strong fiscal balance sheet.

The Canadian government's desire to attract new companies to Canada by reducing the rate of taxation will also result in the realignment of the functions, assets and risks assumed by the existing multinational corporations operating in Canada. The amount of profits a related party can expect to earn depends on the functions performed, assets used and risks assumed by each party. This realignment can serve as a way for multinational corporations to maximise profits globally by taking advantage of Canada's lower corporate tax rate regime. We believe the current economic landscape and lower taxation rates in Canada will lead to a more adversarial relationship between the US and Canada, which has historically been excellent in negotiating issues of double taxation.

II. What this means for business

Firms operating internationally are expected, by shareholders, to maximise their after tax profits. Allocating profits from one tax jurisdiction to another is a legitimate exercise when planned properly and optimising the placement of functions, assets and risks such that profit levels are justified.

Many of the world's leading corporations residing in the US have subsidiaries that operate around the world, including Canada. Multinational corporations have typically sought to allocate their profits to the US versus Canada due to, among other factors, historically lower tax rates. This was often achieved by having many functions performed, risks assumed and assets pledged by US entities versus those of their Canadian affiliates. However, this trend may change as Canadian corporate taxation rates fall below those in the US. Firms may, for the first time, want to report more profits in Canada. Due to the current state of the US economy and the record high deficits incurred by successive American governments, the US will look to increase its audit and inspection activity. This may result in a reversal of current trends where the CRA seeks tax refunds, on behalf of Canadian entities, from the IRS. We may see a more "hardened" IRS, which seeks to extract more revenues from entities operating in the US.

Footnote

1. While low tax rates may be one reason to move profits to certain low tax jurisdictions (by shifting functions, assets and risks to such jurisdictions), other factors exist that explain why certain multinationals move profits between countries with higher tax rates. Reasons include favorable regulatory regimes that protect intellectual property, sharing of intangible developing risk, capital funding and favorable tax credit provisions present in certain higher tax countries.

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