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OECD Presentation Resources and Transfer Pricing: A Canadian Perspective San Jose 31 March – 4 April 2014.

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Presentation on theme: "OECD Presentation Resources and Transfer Pricing: A Canadian Perspective San Jose 31 March – 4 April 2014."— Presentation transcript:

1 OECD Presentation Resources and Transfer Pricing: A Canadian Perspective San Jose 31 March – 4 April 2014

2 2 Overview  Transfer pricing and resource economics  Audit considerations  The Canadian resource tax environment  Case studies Commodity marketing transactions Business restructures and expansion Intangibles in the mining sector

3 3 Transfer Pricing and Resource Economics  Renewable v non-renewable resources Expectations of scarcity affect supply and demand dynamics and therefore price  Demand and supply realities World v regional markets; resource type  Market structure Levels of competition and market consolidation  The Paradox of Value

4 4 Consideration for Extractive Industries  Facts and circumstances All mines are unique – geography; risk; ore quality  Capital intensity Significant sunk cost investment required  Continued investment Need for continual, often significant, injections of capital over life of project

5 5 Consideration for Extractive Industries (cont’d)  High cost of knowledge Decisions based on expectations – in order to obtain full data on a mine it must be operated  Commodity price cycles Market prices are volatile – affects decision making over the life of the mine – impact from a myriad of economic factors on various stages of value chain

6 6 Consideration for Extractive Industries (cont’d)  How do such factors affect the market, investment decisions, inter-company pricing and taxation?

7 7 Mineral Extraction: Stages and Functions

8 8 Price Determination  In the short-run, price of an intermediate natural resource is a function of the price of the final product  Price differences exist between stages of extraction, processing and distribution  For certain resources market prices exist for the intermediate product – oil quoted as $ / barrel  Crucial to understate stage of pricing in the value chain Microeconomic and macroeconomic, endogenous and exogenous, factors impact expected market pricing

9 9 Price Determination (cont’d)  Price is influenced by: Demand for minerals and resources Increasing industrialization of China and India Regional and global economic activity Demand for substitutes Mine production and processing output Political issues; project costs; technological advances Supply chain challenges Production Processing Distribution

10 10 Source of Price Changes  Final product price fluctuations  The price of inputs remain unchanged (inelastic)  Cost of labor and industrial inputs  Transportation costs – may be affected by market changes  Distribution and marketing costs  Technology and machinery - efficiency and availability

11 11 Level of Market and Pricing Issue

12 12 Level of Market and Price Issue (cont’d)  Identify and understand potential difference in price at various stages of the value chain  Stage of value chain impacts: Function, asset and risk contribution Comparability Market prices and benchmarking  Look to market for reasonable arm’s length pricing and transaction models

13 13 Resource Value Chain and Transfer Pricing  Mining  Oil and Gas

14 14 Economic Rent  Typical v atypical returns – excess returns above normal levels  Economic rent as the returns realized after paying for all factors of production, including funds committed to the project  Not uncommon for resource sectors to accrue economic rent Commodity boom – periods of ‘excessive’ returns

15 15 Economic Rent (cont’d) Economic rent in resource sector:  Scarcity: Demand and supply constraints Elasticity of demand and supply  Ore quality: Reduces processing Commands higher price in market Comparative advantage lost to transport  Technology: Advanced technology Specialization to mine site or industry

16 16 Example: Economic Rent from Scarcity  Low price Turnover $80 Fresh extraction 20 Grinding costs 10 Development costs 18 Management fees 8 Marketing costs 5 Freight 9 Operating income 10 ‘Normal’ earnings 30 Differential (20)  High price Turnover $130 Fresh extraction 22 Grinding costs 10 Development costs 18 Management fees 8 Marketing costs 6 Freight 9 Operating income 57 ‘Normal’ earnings 30 Differential 27

17 17 Example: Economic Rent from Technology  Low price Turnover $100 Fresh extraction 20 Grinding costs 10 Development costs 18 Management fees 8 Marketing costs 5 Freight 9 Operating income 30 ‘Normal’ earnings 30 Differential 0  High price Turnover $100 Fresh extraction 20 Grinding costs 10 Development costs 12 Management fees 8 Marketing costs 5 Freight 9 Operating income 36 ‘Normal’ earnings 30 Differential 6

18 18 Attributing Economic Rent  At arm’s length a number of factors influence contracts  Unrelated parties negotiate to protect economic interests  Third party contracts include complex formulae which consider: Net return Content and composition of concentrate Production costs Market power Risk Contract duration and potential re-negotiation Terms of payment

19 19 Arm’s Length Contracts Recall: Nature of contract is dependent on resource and industry 1.Price paid: Zinc: $1.02/lb x = $2 250 /MT (average LME spot price) Silver:$17.00 / oz 2.Expected value of resource realized by processing Zinc:55% x 85% = 46.75% x $2 250= $ Silver:(5oz – 3oz) x 70% x $17.00= Total Payable= $ Processing deductions Processing Costs: Base fee = $ Adjust for price change: $2 250 – = 250 x 4C/1$= $ Penalty for Fe8.5% - 8% = 0.5% x $1.50 $/1%= (0.75) Penalty for MgO0.5% % =.015% x 2.00 $/0.1%= (3.00) Total deductions = (268.75) Paid to mine= $ Percentage realized by mine= 75%

20 20 Arm’s Length Contract (cont’d)  Terms are dependent on mineral/resource and bargaining power of mine and processor  Key elements Expected prices – primary and secondary metals Expected production output – 55% and 85% ‘Penalties’ for impurities Price adjustments accounting for additional metals and changes in market price  Comparable Uncontrolled Transaction (CUT)

21 21 Audit Considerations  Types of transactions: Resource sales – final product and/or concentrate Financial transactions – debt; equity; derivatives Equipment transfer – sales and leases Intangibles – creation and transfer of know-how  Nature of resource Understanding demand and supply dynamics; levels of competition and regulation  Industry and market value chain Note: Oil and gas markets have changed significantly since the 1980s

22 22 Audit Considerations (cont’d)  Pricing benchmarks Market indices and posted rates Comparability at concentrate level as a significant challenge  Mining project life cycle Differences in cost, market price over time  Functional roles and capacity of related parties With consideration of the assets used and the risks expected by the market

23 23 Canadian Resource Tax Environment  Income taxes Federal and provincial levels  Mining taxes Provincial level – including royalties  Three distinct stages: Exploration and development Commercial production Processing

24 24 Canadian Resources

25 25 Provincial Resource Royalties  Provinces and territories administer royalties  Royalty rates and calculations differ across regions and mineral/resource  Royalties are intended to be non-distortionary Taxes on economic rents do not affect investment and operational decisions  Link between various levels and form of taxation Can help identify transfer pricing issue and Taxpayer motivation

26 26 Provincial Resource Royalties (cont’d)  Example: Saskatchewan Resource Royalty Base payment: Net base payment = Gross base payment – [Crown royalties + Freehold royalties + Saskatchewan resource credit – Excess deductions] – Tax credits (prior year) Profit Tax: Net profit tax = Gross profit tax – Base payment credits – Tax credits

27 27 ‘Half-time’ Thoughts  Understanding the resource market World vs. regional markets  Economic factors unique to resource industry and mining company transactions  The resource value chain and system profits  Identifying the stage of the transfer pricing issue: extraction, processing, distribution  Economic rents  Types and form of taxes typically applied to resources

28 28 Case Studies  Commodity marketing (1) – Related marketer  Commodity marketing (2) – Functional deficiency  Commodity marketing (3) – Financial transactions  Business restructuring / expansion  Mining and intangibles

29 29 Commodity Marketing - General  North American oil and gas industry as wonderfully transparent source of arm’s length terms, conditions and pricing Deregulated and highly competitive  Marketers exist to facilitate trade Interested in underlying value of resource Paid on a per volume basis: $X / BTU or / ST Marketers enter into financial transactions – speculative and hedges Various types of marketers, depending on functional and risk capacity – impacts value and pricing

30 30 Commodity Marketing – General (cont’d)  Arm’s length contracts historically based on netback pricing terms and conditions – resale price  Inter-company commodity marketing Centralization of functions and risks Emphasis on Parent company’s control and intangibles Location of activity v signed contract What is/are value added activity?  Ultimately transactions occur given demand for the resource in question

31 31 Case Study 1: Commodity Marketing – Related Party Marketer  Facts: US Parent USCO distributes Canadian Resource A in US CANCO is a mining entity Three mines in Canada - oligopoly CANCO distributes Resource B in Canada for USCO Canadian operations account for more than 30% of world production of Resource A

32 32 Case Study 1: Related Party Marketer

33 33 Case Study 1: Related Party Marketer  Taxpayer model Fixed commission fee based on netback pricing (NBP) NBP = End Selling Price – Marketing Fee – Costs (agreed to in contract negotiation) Essentially resale price:

34 34 Case Study 1: Related Party Marketer  Taxpayer Rationale: “The ultimate discount...is based on the principle that the gross margin to be earned...must cover operating costs and earn a reasonable return for the functions.” (CDocs)  Did not use arm’s length distribution fee comparables  Provided little economic rationale or analysis of fees  Commission fees selected by the Taxpayer resulted in a profit split of 55 / 45 in favour of the mine (CANCO)  The Taxpayer used a Profit Split comparability analysis to verify the commission fees – assumed the answer

35 35 Case Study 1: Related Party Marketer  The CRA challenged the validity of the fees and the usefulness of the profit split analysis given the differences in industry and commodity resource  The Taxpayer intimated that they would use the profit split analysis on a go-forward basis  The profit split was a ‘sanity’ check for the CRA – clearly the results were not arm’s length

36 36 Case Study 1: Related Party Marketer  Characterization: CANCO as producer/processor of Resource A USCO as a ‘routine’ commodity distributor  Taxpayer claimed USCO provided much more than distribution functions Supply and product management Integration of activity required application of profit split

37 37 Case Study 1: Related Party Marketer  ‘Routine’ implying no significant intangibles Processes Technology  Taxpayer’s claim of non-routine or high integration counter to market data and realities  USCO carries same expectations and risks, and completes the same functions as comparables  Corporate reality v arm’s length expectations

38 38 Case Study 1: Related Party Marketer  The CRA accepted netback pricing in principle: Proposed use of Berry ratio to determine level of fees Berry ratio = Gross Profit / OE OE as representing value added activity Reward entity in line with functions performed as captured in OE  Arm’s length producer expects to capture/carry price changes – price risk  Profit split linked to prevailing market price and so unreasonably rewards distributor in good times An issue of Base Erosion (BEPS) – think of royalty calculation

39 39 Case Study 1: Related Party Marketer CRA:  Relied on independent functional and economic analysis  Analysis of changing market dynamics – crucial  Comprehensive review of comparable data  USCO expected to act as evident in the comparable and other market indicators  Berry ratio used to measure distributor’s role directly – ‘back’ us into expected arm’s length net back price

40 40 Case Study 1: Related Party Marketer  Commission fee Implied by Berry ratio analysis:  Recall Taxpayer commission fee:

41 41 Case Study 1: Related Party Marketer  Taxpayer argued ‘strategic management’ of Parent  Oligopolistic nature of industry  Assessment is under consideration in competent authority  Future years under an APA are also part of the negotiation process  Fingers crossed

42 42 Case Study 2: Commodity Marketing – Functionally Deficient Marketer  Facts: Resource extracted in Canada Sell Resource into US market through USCO – transfer of ownership at border US marketing hub contracts with 3 rd party end users throughout US US marketing hub has no employees or physical office Marketing is outsourced to division of CANCO Contracts are signed by US company

43 43 Case Study 2: Functionally Deficient Marketer

44 44 Case Study 2: Functionally Deficient Marketer  Issues Transfer price of resource Transfer price for US ‘marketing’  CRA audit Completed functional analysis Industry review and analysis  Assessing positions considered Transfer pricing Permanent Establishment

45 45 Case Study 2: Functionally Deficient Marketer Taxpayer model:  Provided market CUPs for net back price of resource Net Back Price = End Selling Price – Transportation – Marketing Fee  Outsource marketing functions to Canada – paid Canada its Cost Changed to Cost + 7.5% based on comparability analysis

46 46 Case Study 2: Functional Deficient Marketer CRA position:  Verified marketing fee CUPs and transportation costs Accepted terms of sale of resource  Challenged remuneration of USCO for marketing functions US did not complete functions of marketer Assets were routine if valuable Marketing risks are mitigated by the netback pricing terms

47 47 Case Study 2: Functional Deficient Marketer Considered two assessing positions  Permanent establishment Mind and management was clearly in Canada  Transfer pricing Did not accept ‘outsourcing’ model Marketing fee CUPs are the benchmark for Canada’s functional role Taxpayer’s representations for PE defence supported CRA transfer pricing model

48 48 Case Study 2: Functional Deficient Marketer  Taxpayer argued that US profits were attributable to three assets: Import license Transportation assets Sales contracts  CRA argued all three contracts were routine for this transaction and that Functions were the key determinant of profit Industry and Taxpayer documentation supported position Risks limited by the netback formula – essential for resource distribution transactions

49 49 Case Study 2: Functionally Deficient Marketer  Re-assessed Taxpayer based on transfer pricing legislation  Relied on third party contracts Unrelated marketing contracts Unrelated delivery and distribution contracts  Position was up-held in Competent Authority negotiations

50 50 Case Study 2A: Functionally Deficient Marketer  Similar fact base as above Resource extracted in Canada Resource sold into US market through US marketing hub with no employees USCO ‘outsources’ marketing functions to CANCO US signed import license, transportation and sales contracts  Audit challenges Statue barred dates Incomplete functional analysis Limited Taxpayer documentation

51 51 Case Study 2A: Functionally Deficient Marketer

52 52 Case Study 2A: Functionally Deficient Marketer Taxpayer position:  Reasonable to ‘outsource’ functions  Key profit drivers: right to deliver and sell gas  USCO exploited ‘arbitrage’ opportunities

53 53 Case Study 3: Functional Deficient Marketer  Relied on industry knowledge  Appealed to function, asset and risk profiles of related parties Functions as key determinant of the marketers profit Assets as non-contributory Risks as limited, but identifiable in US  Contracts Multiple performance guarantees – internal and external

54 54 Case Study 3: Functional Deficient Marketer CRA analysis and position  Important fact difference – ability to exploit arbitrage opportunities Relies on functions – people on the ground However, does create risk in this transaction USCO had signed contracts – though guarantees were in place  Required to measure risk of USCO

55 55 Case Study 2A: Functionally Deficient Marketer  For any transaction to exist, rational parties must recognize value in the arrangement This is reinforced by the arrangement itself: consider why GasCo1 would not sell to lake and End User directly  Identified types of risks associated with the transaction and accorded each party a share of these risks

56 56 Case Study 2A: Functionally Deficient Marketer Consider:  Two sources of gas: GasCo 1(75%) and CasCo 2 (25%)  Four types of risk: ¾ GasCo 1; ¼ GasCo 2 Sales risk Purchase risk Transport risk Supply risk

57 57 Case Study 2A: Functionally Deficient Marketer  Appealing to the shares of risk determined by our analysis, we attributed the following to USCO:  Assume USCO/CANCO bear risk of supply: 1/16 of all risk = 6.25% of π  Assume supply risk bore by third parties: 1/12 of all risk = 8.33% of π  Quantum implied was supported by arm’s length contracts

58 58 Case Study 3: Commodity Marketing Financial Transactions  At arm’s length commodity marketers often enter into financial transactions Transportation optimization Arbitrage – speculative transactions  Generally resource owners seek to mitigate risk – only enter into hedge contracts  In related party context risk will be shifted  For the marketer, however, functions remain the key determinant of profit

59 59 Case Study 3: Commodity Marketing Financial Transactions

60 60 Case Study 3: Commodity Marketing Financial Transactions  Issue : Transfer of risk Functional capacity Legal ownership – contracts Speculative transactions are ‘notional’ don’t require supply  Assessing positions: Pricing – profit splits: rely on arm’s length contracts Re-characterization: would parties enter into this transaction

61 61 Case Study 4: Business Restructuring  Canadian drilling company  Secures drilling contract in Europe  Establishes European subsidiary  Local labour regulations require employment of local drilling apprentices  Drilling contract for 5-year project

62 62 Case Study 4: Business Restructuring  Related party transactions Sale of drills from CANCO to EuroCO Provision of management by CANCO Provision of drilling services by CANCO CANCO hired and trained EuroCO employees  Taxpayer model: Drills sold at Cost + 10% Management fee of Cost + 10% CANCO drilling services of Cost + 10%

63 63 Case Study 4: Business Restructuring

64 64 Case Study 4: Business Restructuring CRA audit position  Sale of drills problematic but reasonable  Transaction really restructuring or a business expansion – CANCO as ‘entrepreneur’  Implied profit split Tested PortCo contribution – ‘residual’ earned by CANCO Weighed heavily to CANCO in early years, but allows for adjustment to account for increased PortCo role

65 65 Case Study 4: Business Restructuring  A variation:

66 66 Case Study 4: Business Restructuring  Insertion of an OpCo in a Tax Haven  Equipment sold to the OpCo in Luxembourg  LuxCo signs final drilling contract CANCO and PortCo receive Cost +  Approaches: Re-Characterization – challenge sale of drills and transfer of business to LuxCo Pricing – value transfer of drills AND transfer of contracts and business Pricing – treat as a series of transactions and value contributions through Functions, Assets and Risks: determine reasonable profit split

67 67 Mining and Intangibles  Identification of the intangible  Differentiation of the nature of intangible  Intangible transfer or service provision  Contribution to operational profitability  Contribution of the development  Application of profit split methodologies  Generally technology and know-how

68 68 Case Study 5: Technology Royalty Facts:  Non-AL royalty payment for technological know-how  Know-how involved the application of a mining process  Process was developed in the early 1960s and built off publicly available concept  Canadian involvement in technology’s development

69 69 Case Study 5: Technology Royalty (cont’d)  Patents relating to the process expired by the late 1970s  Taxpayer had failed to license the technology at AL  Taxpayer argued that the payment was linked to ‘core technology’

70 70 Case Study 5: Technology Royalty (cont’d) Q: Is a royalty payment reasonable? A: It depends Fundamental considerations Diffusion of technological know-how In-house skilled personnel Cost and financing

71 71 Case Study 5: Technology Royalty (cont’d)  Diffusion of Technology CANCO used technology for 30+ years Expired patents  Personnel CAN involved in development CAN responsible for enhancements  Cost ?

72 72 Case Study 5: Technology Royalty (cont’d)Example (cont’d)  Challenged Reasonableness of payment Duration of agreements Economic circumstances Favourable conclusion achieved – just about

73 73 Case Studies: Final Thoughts  Importance of industry and company data  Thorough functional analysis  Sound application of economic theory to facts of the file  Significance of individual case’s facts and circumstances

74 74 Case Studies: Final Thoughts (cont’d)  Identify internal value chain and system profits  CUPs may be difficult to obtain Request information from foreign entity Arm’s length processing contracts Third party sales contracts  Industry knowledge to create framework for transfer pricing model  Useful to consider more than one methodology – verification of results

75 75 Mining, Resources and Transfer Pricing  Unique economic factors to be considered  Comparable prices Minerals, equipment, processing and distribution  Third party and market data as essential Independent research; industry annual reports  Mining is a geographically specific operation  Control of resource is essential to realizing value

76 76 ¿Preguntas?


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