Principal Issues: In a particular situation, should losses from USco, caused by overcapacity, be absorbed by Canco?
Position: General Comments
Reasons: Question of fact
Federal Tax Roundtable, 5 October 2012
2012 APFF Conference
Question 23
Risk allocation and control
In applying the arm's length principle to the transfer price between a Canadian corporation and a non-resident corporation with which it does not deal at arm's length, the OECD guidelines state in paragraph 9.20 that there are two relevant factors to consider in determining which of the two corporations bears a particular risk: (1) which corporation exercises the most control over the risk; and 2) which corporation has the financial capacity to assume it.
A Canadian corporation ("Canco") entered into an exclusive supply agreement with a US customer with which it deals at arm's length. According to this agreement, Canco had to establish a plant in the United States near the customer to reduce transportation costs. A US corporation ("USco") wholly owned by Canco was then created to manufacture products for the US customer. The production capacity of the new plant was determined by Canco based on the anticipated sales volume for the coming years for the US customer. USco hired staff to operate the plant, but none of its employees has decision-making authority over USco's strategic direction. This power remains at Canco.
During the first four years of operation, USco's single-client sales volume was well below expectations for which the plant capacity had been established. As a result, USco is unable to cover its fixed costs and incurs significant losses each year. If no action is taken, there is no reason to believe that the situation will change in the years to come.
Question to the CRA
Given that Canco controls USco's strategic direction (for example, identifying new customers for USco or reducing the capacity of the plant), and that USco does not have the financial capacity to assume the risk associated with the deal concluded with the customer, should losses from USco, caused by overcapacity, be absorbed by Canco?
CRA response
The situation described in your question appears to us to be an actual situation. We have contacted the Compliance Programs Branch, which informed us that a situation similar to the one you presented in your question is currently under study. Consequently, we will not comment on this situation.
Furthermore, if the situation described above relates to proposed transactions, we invite you to apply for an advance ruling in accordance with Information Circular 70-6R5, Advance Income Tax Rulings and Technical Interpretations or to request an advance pricing arrangement in accordance with Information Circular 94-4R, International Transfer Pricing: Advance Pricing Arrangements (APAs).
Anne Dagenais
(613) 957-2121
2012-045422