The shifting tides of TP: a closer look at tax controversy driving legislative changes
Christine Ramsay and Samer Wani of Deloitte Canada and Subhabrata Dasgupta of Deloitte Malaysia highlight significant legislative developments in several jurisdictions as the world strives to keep pace with the OECD's Transfer Pricing Guidelines.
The transfer pricing (TP) landscape has been constantly evolving over the past two decades, with several iterations of the guidance being released by the OECD in its publication Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD Guidelines), and the latest editions that incorporate the outcomes of the OECD’s BEPS project. Conversely, the TP legislation in many countries did not keep pace with these updates to the OECD Guidelines.
In some countries, TP legislation does not incorporate the OECD Guidelines to give them force of law. In this current, rapidly changing business environment that is driving cross-border complexities within global businesses and supply chains, tax controversy is on the rise. Tax authorities in many countries have had unfavourable outcomes in controversy matters, resulting in the need for the modernisation of their local TP legislation to better align with international consensus.
The OECD Guidelines reflect a broad alignment on certain TP principles between members of the OECD/G20 Inclusive Framework on BEPS. The OECD Guidelines have been updated multiple times over the years since their initial approval by the OECD Council in 1995. These updates are the results of the fundamental changes taking place across industries, economies, and international trade around the world.
Generally, statutory TP legislation has not kept pace with revisions to the OECD Guidelines over the years. The varying levels of conformity in statutory legislation with the OECD Guidelines worldwide have led to a mismatch between the interpretation of the OECD Guidelines and the administration of TP laws across jurisdictions. These mismatches have inevitably led to an increase in TP controversy. In recent years, several cases have been adjudicated in favour of taxpayers, as tax authorities were not able to successfully apply legislative provisions to effect TP adjustments based on the latest TP concepts in the OECD Guidelines.
As a result, more and more tax administrations are modernising their legislative provisions to better align with the OECD Guidelines in a greater level of detail. This is a positive development, as alignment of laws that conform to international consensus and that are more detailed than in the past should provide multinational enterprises with more explicit guidance on how to set transfer prices and should allow for more efficient resolution of cross-border tax disputes by competent authorities under mutual agreement procedures (MAPs).
However, much will depend upon how aligned the amended legislative provisions are with OECD concepts across jurisdictions, and how these laws are administered through local processes and tax authority practices.
Spotlight on legislation in Canada
Canada is one such jurisdiction where TP legislation is only now catching up with the OECD Guidelines.
Canada’s existing TP legislation was enacted in 1997, and at that time it was stated that the intent of the legislation was to align Canadian TP laws with the 1995 edition of the OECD Guidelines. While the OECD Guidelines have undergone significant revisions since then, the TP legislation in Canada has remained substantively unchanged.
Historically, Canada’s Department of Finance (Finance Canada) and the Canada Revenue Agency (CRA) have considered the legislation as being adequately reflective of the OECD Guidelines. Most recently, with respect to the 2017 edition of the OECD Guidelines, the Canadian Federal Budget document of February 27 2018 stated that “Canada has adopted the revised OECD Transfer Pricing Guidelines and has played an important role in developing additional guidance on issues identified in the course of the BEPS project.”
Jurisprudence in Canada in recent years, on the other hand, has highlighted gaps between the application of the legislation and the CRA’s interpretation of the OECD Guidelines, as the CRA has sustained several high-profile court case losses to taxpayers on these matters. In response, in June 2023, Finance Canada issued a consultation paper to gather stakeholder input on a range of questions and proposals related to Canada’s TP legislation.
Based on the outcomes of the recently adjudicated TP cases, there is a growing recognition by Finance Canada that the Canadian TP legislation only provides a high-level approach to the arm’s-length principle. Furthermore, Canadian TP legislation does not explicitly detail how it should be applied, and in Finance Canada’s view, there has been an overemphasis on intra-group contracts, rather than on the factual substance of the transactions.
The strong focus on contractual terms in Canada has led to allocations of income that, in the view of Finance Canada, did not correspond to value creation through the underlying economic activity. The dichotomy between Finance Canada’s interpretation of the OECD Guidelines and the gap in the current legislation has benefited certain taxpayers and resulted in a significant loss of tax revenue for the government. In Finance Canada’s words in the aforementioned consultation paper, “[the] ability to shift income based on intra-group contracts and other formal arrangements that disconnect entitlement to income from underlying economic activity is inappropriate in policy terms.”
The proposed legislative changes contained within the consultation paper published by Finance Canada concern amendments to the TP adjustment rule set out in Section 247 of the Income Tax Act (Canada) (the Act). These proposed amendments aim to align the TP adjustment rule in Section 247 of the Act with the OECD Guidelines, with the objective of providing more explicit details on the application of the arm’s-length principle in Canada’s TP legislation.
As part of its proposal, Finance Canada proposes to incorporate certain concepts from the OECD Guidelines into Section 247 of the Act, including steps for the delineation of transactions by identifying the conditions and economically relevant characteristics to a controlled transaction and comparing these to comparable transactions between independent enterprises. Finance Canada also proposed to introduce a consistency rule, which will require that the Canadian TP legislation be applied in a manner that best achieves consistency with the OECD Guidelines unless context requires otherwise.
Whether Finance Canada successfully aligns the legislation with the OECD Guidelines and the international consensus will depend largely on the interpretation and administration of these proposed rules by the CRA. While the intention of Finance Canada is to implement changes to the Canadian TP rules to tighten up the interpretation of the application of the arm’s-length principle, it remains to be seen if these proposed changes will accomplish this objective when tested in court.
The reduced reliance on terms and conditions of intra-group contracts will introduce an increased level of subjectivity to TP through the determination of the economically relevant characteristics to delineate a transaction and the appropriate associated conditions. As a result, taxpayers may initially face increased uncertainty and more complex TP controversy in Canada. There is no doubt that Canada’s TP landscape will be a closely watched space in the coming years.
Legislative developments in Australia and the UK
It is instructive to see the impact of similar developments in Australia and the UK, two jurisdictions with strong cultural and economic similarities to Canada. Australia and the UK have several years of experience with the implementation of modernised and OECD-based TP rules.
Legislative changes in Australia were driven by TP controversy. The impact of the changes has been increased compliance, albeit predictably at a cost for the Australian Taxation Office (ATO) and taxpayers. The ATO has invested significantly in analytics capability. Most large taxpayers are now on a routine review cycle with the ATO, with reviews conducted on a ‘whole-of-tax’ basis, both direct (including TP) and indirect taxes. The documentation requirements in Australia are onerous, with relatively high compliance-related penalties. There has also been a risk-based review approach that seems to have limited the amount of TP controversy.
The UK also adopted the OECD Guidelines into its domestic law. The UK has a very effective MAP and advance pricing arrangement (APA) programme. The MAP programme is effective due to the UK’s vast treaty network, while the APA programme deals with complex and significant matters, which is helpful to taxpayers. Close alignment with the OECD concepts in the UK has generally meant less room for interpretation and tax resources being channelled towards controversy management for larger and more complex situations.
In considering the observed outcomes in Australia and the UK since their adoption of OECD-based TP rules, subsequent changes to the CRA’s audit approach, MAP programme, and APA programme are likely required if the CRA is looking to achieve similar outcomes in Canada. It would be expected that these changes would require additional investments by the government of Canada and without that, taxpayers may face increased uncertainty and more complex TP controversy in Canada in the short term.
Growing legislative activity throughout Southeast Asia
Southeast Asia, being one of the fastest-growing regions in the world, is attracting significant foreign direct investments, and in turn more TP scrutiny on multinational enterprise businesses. Since 2020, there have been several amendments to tax laws in Southeast Asian countries, driven by actual and anticipated controversy outcomes, as well as to reinforce the tax authorities’ interpretation and application of the OECD Guidelines. Some notable amendments are the following.
Indonesia – a secondary adjustment was introduced in 2021 by the Tax Regulations Harmonization Law, Law No. 7/ 2021, to treat any primary TP adjustment as a constructive dividend, subject to withholding tax. This emanated from historical controversy around the legal basis to impose secondary adjustment.
Malaysia – the law has been amended, effective 2021, to give recharacterisation power to the tax authority and to introduce a surcharge of up to 5% on gross TP adjustment. Simultaneously, a new provision introduced documentation-related penalties. These changes, respectively, resulted from setbacks in the courts with respect to the recharacterisation of certain controlled transactions and the intention to emphasise TP compliance for businesses with tax attributes. Through the Income Tax (Transfer Pricing) Rules 2023, dated May 29 2023, the arm’s-length range has been defined as the 37.5th to the 62.5th percentiles, with formal endorsement for the median (the mid-point of these percentiles) as the point of adjustment during audit. These also stemmed primarily from TP disputes decided against the tax authority on the use of the median instead of the entire interquartile range.
Philippines – rules and regulations, although executive enactments only, have been introduced to reverse decisions on issues where the tax authority had lost previously. For instance, in Revenue Memorandum Order No. 63-99, the tax authority enacted the rule that allows it to deem an interest on shareholder advances, after it lost a case in court on the same issue.
Singapore – local TP guidelines were updated in 2021 through the Transfer Pricing Guidelines (Sixth Edition), issued by the Inland Revenue Authority of Singapore on August 10 2021, to endorse some of the OECD guidance on financial transactions and cost contribution arrangements. Arbitration has been introduced for MAP stalemates, and self-initiated retrospective downwards adjustment for past years has been discouraged.
Thailand – regulations were issued through the Notification of the Director – General of Revenue Department on Income Tax (No. 407), issued by the Thai Revenue Department on September 30 2021, on the required content for local files, which are effective for 2021 and subsequent years.
Vietnam – the latest TP regulation, Decree 132/2020/ND-CP, was introduced on November 5 2020 to redefine the arm’s-length range as the 35th (previously the 25th) to the 75th percentiles, and the provision on deductible interest expenses was revised to net interest expenses up to 30% of accounting EBITDA, with the non-deductible amount being eligible for carry-forward for up to five years.
An evolving landscape
The non-exhaustive instances of changes in tax laws highlighted in this article reinforce the notion that tax authorities continue to mature in their approach, both technical and legal, to deal with the outcomes of TP controversy and to provide clarity on their interpretation of local laws and the OECD Guidelines.
In some cases, these amendments may help to resolve ongoing disputes. However, unless specifically allowed by legislation, should tax authorities pursue retroactive application of any changes, their actions could lead to more disputes.