• Transfer Pricing Secondary Adjustments
  • April 2, 2012
  • Law Firm: Miller Thomson LLP - Toronto Office
  • Primary Adjustments

    Where a transaction between a Canadian resident and a non-resident with whom the Canadian resident does not deal at arm’s length is not consistent with a similar arm’s length transaction, Canada’s transfer pricing rules allow the CRA to adjust the transaction prices and other relevant amounts to the arm’s length amounts for Canadian income tax purposes.

    For example, if a Canadian resident pays a non-arm’s length non-resident a price of $1,000 for the purchase of goods, other property or services and an arm’s length party in similar circumstances would only have paid $700, then the Canadian resident is deemed to have paid the lower arm’s length price, i.e., $700. The $300 excess over the lower arm’s length price will be disallowed as a deduction where the Canadian resident has deducted the cost of the goods, other property or services in computing its income. Management fees, royalties and interest paid by a Canadian resident to a non-arm’s length non-resident are commonly subject to review and adjustment on this basis. Where the price paid is treated as cost of inventory or capital property, the lower arm’s length price will become the Canadian resident’s cost for tax purposes.

    This type of transfer pricing adjustment is called a “primary adjustment”.

    Secondary Adjustments

    Where the Canadian resident subject to a primary transfer pricing adjustment is a corporation, the CRA generally treats the amount of the primary adjustment, i.e., the disallowed portion of the price paid to the non-arm’s length non-resident, as a shareholder benefit under subsection 15(1) of the Tax Act which is deemed to be a dividend subject to withholding tax under paragraph 214(3)(a) of the Tax Act. This treats the portion of the price paid to the non-resident in excess of the arm’s length price as being tantamount to a distribution of corporate surplus. This is referred as a “secondary adjustment.” In the above example, the $300 excess over the arm’s length price would be a deemed dividend subject to withholding tax.

    The CRA’s policy with respect to assessing withholding tax for such secondary adjustments is set out in paragraph 211 of CRA Information Circular 87 - 2R on International Transfer Pricing.

    The Budget proposes to amend section 247 of the Tax Act to provide specifically for withholding tax assessments for secondary adjustments. The proposed amendments also codify, to some extent, existing CRA administrative policy for relief from the secondary adjustment withholding tax if the non-resident repays or “repatriates” the excess amount to the Canadian corporation.

    The proposed amendments are welcome because they provide specific rules for an area that was previously only dealt with under CRA administrative practice. The proposed amendments also specify an exception and a taxpayer favourable adjustment in relation to secondary adjustment withholding tax assessments.

    The proposed amendments provide:

    Amount: The amount subject to withholding tax is the sum of the Canadian corporation’s income and capital transfer pricing adjustments under section 247, but with the capital adjustments determined on a gross basis. And, this amount is determined as if the Canadian corporation had undertaken no transactions other than those transactions in which the particular non-arm’s length non-resident participated.

    Reduction: The amount subject to withholding tax is reduced by transfer pricing adjustments in the Canadian taxpayer’s favour.

    Deemed Dividend: The excess amount is treated as a deemed dividend for withholding tax purposes. Therefore, the withholding tax rate under any applicable tax treaty will be the rate for dividends. Nothing is said about when such deemed dividends will qualify for the lower dividend withholding tax rate available under many treaties where the shareholding meets a specified minimum threshold.

    Timing: The deemed dividend is deemed to be paid at the end of the taxation year in which the relevant transactions occurred.

    CFA Exception: There is an exception for a transaction with a non-resident that is a controlled foreign affiliate (“CFA”) under subsection 17(15) of the Tax Act. A primary transfer pricing adjustment in relation to a transaction with this type of CFA will not give rise to a deemed dividend subject to withholding tax. Excess payments by the Canadian corporation to such a CFA are considered to be equivalent to downstream capital contributions to the foreign affiliate rather than upstream distributions of surplus to foreign shareholders. Therefore, a withholding tax assessment is not appropriate. A subsection 17(15) CFA is generally a CFA controlled by the taxpayer and/or Canadian residents with whom the Canadian corporation does not deal at arm’s length. The non-resident must qualify as this type of CFA throughout the period during which the subject transaction or series of transactions occurred. The broad scope of the term “series of transactions” (see the recent GAAR decision of the Supreme Court of Canada in Copthorne Holdings Ltd.) may come to be a problem for this exception.


    Paragraphs 212 and 213 of CRA Information Circular 87 - 2R on International Transfer Pricing and CRA Transfer Pricing Memorandum TPM - 02 set out the CRA’s administrative policy for relief from secondary adjustment withholding tax assessments where the non-resident repays the excess amount to the Canadian resident.

    The proposed amendments codify this CRA administrative policy to a limited extent by providing:

    Reduction for Repayment: The deemed dividend subject to withholding tax may be reduced where the non-resident has paid the Canadian corporation an amount with the concurrence of the CRA. The reduction would generally be the amount of the repayment, although the proposed amendment is not this specific.

    CRA Discretion: The amount of the reduction is the amount that the CRA considers to be appropriate having regard to all the circumstances. This discretion will presumably allow the CRA to continue elements of its current administrative practice, such as denying repatriation relief for abusive transactions, allowing repayment by way of offset of other amounts owing by the Canadian corporation to the non-resident, or creation or adjustment of a shareholder’s loan account, and requiring the taxpayer to accept the primary transfer pricing adjustment and waive objection and appeal rights.

    Arrears Interest: The withholding tax that was or could have been assessed prior to reduction for repayment will still be subject to arrears interest for the period from the date of the deemed dividend to the date of repayment. The CRA may agree to reduction of the arrears interest where the CRA considers such a reduction to be appropriate in the circumstances (including whether the other country provides reciprocal treatment).

    The proposed amendments on repatriation relief are welcome; however, they fall short on the detailed mechanics. Determining all the tax consequences of a repatriation, in all affected taxation years, can be quite complex in some circumstances. This is particularly the case where repayment is effected by way of adjustments to an existing shareholder loan account and/or where a foreign currency is involved. Also, nothing is proposed to address the inequitable CRA position that withholding tax refunds are not entitled to refund interest.

    Application Date

    The changes described above will apply to transactions that occur on or after Budget Day.