CRA recently released a new Transfer Pricing Memorandum (TPM-15) giving detailed guidance on CRA's audit approach to management fees and other charges for intra-group services, including on allocation keys for indirect chargebacks and markups on costs. The document expands considerably upon brief guidance on this topic in CRA's main Information Circular on Transfer Pricing, which dates back to 1999. The new TPM is therefore a useful roadmap for Canadian companies, large and small, that pay service fees to or receive fees from related non-resident entities. It is clear that CRA is expecting a more granular level of detail in documenting intra-group services, even routine ones, than is commonplace in many companies and may not be entirely practical. Taxpayers should carefully consider the level of documentation that currently exists in their organization and whether it needs to be upgraded.
CRA identifies two main issues in evaluating intra-group services: (1) whether a service has been provided and (2) determining the arm's length value of the service. CRA notes that the same framework is to be used consistently whether the Canadian taxpayer is the payor or the recipient of the fee, suggesting that transfer pricing auditors will be considering the bona fides of any fees paid by Canadian companies (not merely leaving the issue of deductibility of such fees as a domestic audit matter).
A services contract or intercompany invoices will only be a starting point for an auditor's analysis under the framework. Taxpayers' documentation should include a detailed description of the services and rationale from both the perspective of the provider and the recipient that establishes the benefit of the service to the recipient.
It's important to note that CRA does not accept certain amounts charged to Canadian subsidiaries, including activity costs of a foreign parent company (also referred to as stewardship costs) and charges for non-Canadian entities in the group. In a welcome development, however, CRA does acknowledge that certain foreign regulatory costs incurred by a foreign parent, such as those related to Sarbanes-Oxley compliance, may benefit Canadian subsidiaries if the requirements overlap with Canadian regulations and in such cases, a charge could be justified, albeit on a case-by-case basis.
As to the methods of charging, the direct method, which attaches specific charges to services, is preferred by CRA and should be used where possible, including if similar services are provided to arm's length parties; however, the CRA acknowledges that an indirect method, i.e., an allocation of pooled costs will often be necessary. In such cases, taxpayers should keep records of the composition of the cost pools in order to justify the amounts in each pool, to separate out any elements that are non-deductible or restricted under Canadian tax law (including stock option amounts, certain interest charges, meals and entertainment charges, etc.) and to select an appropriate allocation key for the particular pool. The new TPM makes it clear that CRA will not accept a one-size-fits-all approach in choosing an allocation key. The TPM instructs auditors not to accept proportion of sales revenue as a single allocation key; rather, the allocation key must be appropriate to the cost. For example, time spent may be appropriate for allocating charges for legal, tax and data processing services and use of a corporate jet; whereas, number of employees may be a more suitable allocation key for internal HR charges. Care should be taken to avoid duplicate costs and in this regard taxpayers should avoid giving different charges similar labels, which can cause confusion on the part of auditors and give rise to requests for further detail that could have been avoided.
The TPM notes that markups should not be automatic and are not warranted in all cases. Instead, the validity of a markup in a particular case will depend on a functional analysis and a detailed review of facts and circumstances. Even where a profit element is justified, the profit element and any savings accruing to the group as a whole must be fairly shared.
In summary, the trend in all aspects of transfer pricing documentation is to ever greater detail, from country-by-country reporting recommended by the CD as part of its BEPS Action Plan to even routine intra-group service arrangements, as elaborated upon by CRA in new TPM-15. If you have concerns about the adequacy of your documentation or are facing an audit, seek privileged advice from legal counsel to mitigate exposure and enhance compliance.