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OECD Presentation
Resources and Transfer Pricing: A Canadian
Perspective
San Jose
31 March – 4 April 2014
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
2
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
3
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
4
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
5
Consideration for Extractive Industries
(cont’d)
 How do such factors affect the market,
investment decisions, inter-company pricing and
taxation?
6
Mineral Extraction: Stages and Functions
Exploratio
n and
Feasibility
Planning
and
Constructi
Operations
Closure
Exploration:
- reconnaisance; locate mineral anomalies
- discovery, sampling
Feasibility:
- decision about economic fesability of mining
Planning:
- mine planning
- environmental/social planning
- closure plan
- environmental assessment
- evironmental and other permits
Construction:
- clearing, stripping, blasting,
infrastructure
- ore extraction
- crushing, grinding, concentrating
- waste rock and tailings management
- wastewater management
- progressive reclamation
- site clean- upl reclamaton;
rehabilitation
- maintenance; environemtnal
monitoring
7
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
8
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
9
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
10
Level of Market and Pricing Issue
Resource Demand
Resource
Price
Resource Supply
Recycling
Processing
Processing
Demand for Concentrate
Captive mine
Mine
Processing
Price of
Concentrate
Supply of Concentrate
Mine
Mine
Mine
11
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
12
Resource Value Chain and Transfer
Pricing
 Mining
 Oil and Gas
Exploration
Upstream
Production
Production
Transportation
Processing
Midstream
Refining
Transportation
Downstream
Marketing
Marketing
13
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
14
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
15
Example: Economic Rent from Scarcity
 Low price
Turnover
 High price
$80
Turnover
$130
Fresh extraction
20
Fresh extraction
22
Grinding costs
10
Grinding costs
10
Development costs
18
Development costs
18
Management fees
8
Management fees
8
Marketing costs
5
Marketing costs
6
Freight
9
Freight
9
Operating income
10
Operating income
57
‘Normal’ earnings
30
‘Normal’ earnings
30
Differential
27
Differential
(20)
16
Example: Economic Rent from
Technology
 Low price
Turnover
 High price
$100
Turnover
$100
Fresh extraction
20
Fresh extraction
20
Grinding costs
10
Grinding costs
10
Development costs
18
Development costs
12
Management fees
8
Management fees
8
Marketing costs
5
Marketing costs
5
Freight
9
Freight
9
Operating income
30
Operating income
36
‘Normal’ earnings
30
‘Normal’ earnings
30
Differential
6
Differential
0
17
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
18
Arm’s Length Contracts
Recall: Nature of contract is dependent on resource and industry
1.
Zinc:
Silver:
Price paid:
$1.02/lb x 2 204.6 = $2 250 /MT (average LME spot price)
$17.00 / oz
2.
Expected value of resource realized by processing
Zinc:
55% x 85% = 46.75% x $2 250
= $1 051.88
Silver:
(5oz – 3oz) x 70% x $17.00
=
23.80
Total Payable
= $1 075.68
3.
Processing deductions
Processing Costs: Base fee = $275.00
Adjust for price change:
$2 250 – 2 500 = 250 x 4C/1$
Penalty for Fe
8.5% - 8% = 0.5% x $1.50 $/1%
Penalty for MgO
0.5% - 0.35% = .015% x 2.00 $/0.1%
Total deductions
Paid to mine
Percentage realized by mine
=$
=
=
10.00
(0.75)
(3.00)
= (268.75)
= $ 806.93
=
75%
19
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)
20
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
21
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
22
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
23
Canadian Resources
24
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
25
motivation
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
26
‘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
27
Case Studies
 Commodity marketing (1) – Related marketer
 Commodity marketing (2) – Functional deficiency
 Commodity marketing (3) – Financial
transactions
 Business restructuring / expansion
 Mining and intangibles
28
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
29
and risk capacity – impacts value and pricing
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
30
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
31
Case Study 1: Related Party Marketer
Mine 1
3rd
Parties
CANCO
Mining and Processing
Mine 2
Mine 3
Mineral Sales
CAN
US
USCO
Parent
US Distribution
3rd
Parties
32
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:
Jun-01
Dec-01
Dec-02
Third party freight and logistical
3.35
3.34
3.43
SG&A
7.65
7.54
6.56
Total Cost per ST
11
10.88
9.99
Commission Rate
21.09
18.50
18.50
Mark-up
10.09
7.77
8.51
91.70%
85.20%
70.00%
Percentage return
33
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
34
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
35
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
36
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
37
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 calculation38
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
39
Case Study 1: Related Party Marketer
 Commission fee Implied
by Berry ratio analysis:
Jun-01 Dec-01 Dec-02
Third party freight
3.35
3.34
3.43
and logistical
SG&A
Total Cost per ST
7.65
11.00
7.54
10.88
6.56
9.99
Commission Rate
implied by CRA
methodology
13.25
12.91
11.99
Mark-up
Percentage return
2.25
2.03
2.00
20.45% 18.66% 20.02%
 Recall Taxpayer
commission fee:
Third party
freight and
logistical
SG&A
Total Cost per ST
Commission Rate
Mark-up
Percentage
return
Jun-01
3.35
Dec-01
3.34
Dec-02
3.43
7.65
11.00
7.54
10.88
6.56
9.99
21.09
10.09
91.70%
18.50
7.77
85.20%
18.50
8.51
70.00%
40
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
41
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 3rd 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
42
Case Study 2: Functionally Deficient
Marketer
CANCO
Sale of
resource
Netback
price
OPCO
(Marketing office)
CAN
100%
USCO 'outsource' marketing
functions to CANCO marketing
division
US
USCO Marketer
3rd Party
Co-Gen
Plant
43
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
44
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
45
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
46
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
47
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
48
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
49
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
50
Case Study 2A: Functionally Deficient
Marketer
(2) Guarantee
(1) Guarantee
CANCO
OPCO
CAN
100%
US
Sells/transports
75% of gas
USCO*
Sells Gas (25% + 75%)
GASCO
1
End
Users
(4) Agreement to
transport 25% of gas
(3) Guarantee
100%
Parent
Sells 25%
of gas
TransC
O
GASCO
2
51
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
52
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
53
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
54
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
55
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
56
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
57
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
58
Case Study 3: Commodity Marketing
Financial Transactions
CANCO
OPCO
(Marketing office)
Sale of
resource
Netback
CAN
100%
price
USCO 'outsource' marketing
functions to CANCO marketing
division
US
USCO Marketer
The marketers 'trade' supply to reduce transport costs
Creates gains and losses
3rd Party
Marketer
59
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
60
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
61
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%
62
Case Study 4: Business Restructuring
Private Owners
CANCO
Parent and
Operating
Company
Provision
of drilling
services
International
Drilling
(CANCO)
Canada secures contract
sells drills and trains
employees
PortCo
63
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
64
for adjustment to account for increased PortCo role
Case Study 4: Business Restructuring
 A variation:
Private Owners
CANCO
Parent and
Operating
Company
International
Drilling
(CANCO)
Canada secures contract
sells drills
Provision
of drilling
services
CAN
Luxembourg
LuxCo
Employee
training
PortCo
65
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
66
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
67
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
68
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’
69
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
70
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
•
?
71
Case Study 5: Technology Royalty
(cont’d)Example (cont’d)
 Challenged
• Reasonableness of payment
• Duration of agreements
• Economic circumstances
Favourable conclusion achieved – just about
72
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
73
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
74
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
75
¿Preguntas?
76