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

OECD PresentationResources and Transfer Pricing: A Canadian PerspectiveSan Jose31 March – 4 April 2014

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

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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

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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

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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

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Consideration for Extractive Industries (cont’d)

How do such factors affect the market, investment decisions, inter-company pricing and taxation?

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Mineral Extraction: Stages and Functions

Exploration and

Feasibility

Exploration:- reconnaisance; locate mineral anomalies- discovery, samplingFeasibility:- decision about economic fesability of mining

Planning:- mine planning- environmental/social planning- closure plan- environmental assessment- evironmental and other permitsConstruction:- 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

Planning and

Constructi

Operations

Closure

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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

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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

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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

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Level of Market and Pricing Issue

ResourcePrice

Price ofConcentrate

Mine

Mine

Mine

Supply of Concentrate

Resource Demand

Recycling

Processing

Mine

Captive mine

Processing Processing

Demand for Concentrate

Resource Supply

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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

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Resource Value Chain and Transfer Pricing

Mining Oil and Gas

Upstream

Midstream

Downstream

Exploration

ProductionProduction

Transportation Processing

MarketingMarketing

Refining Transportation

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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

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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

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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


Management fees 8

Marketing costs 6

Freight 9

Operating income 57


Differential 27

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Example: Economic Rent from Technology

Low price

Turnover $100

Fresh extraction 20

Grinding costs 10


Management fees 8

Marketing costs 5

Freight 9

Operating income 30


Differential 0

High price

Turnover $100

Fresh extraction 20

Grinding costs 10


Management fees 8

Marketing costs 5

Freight 9

Operating income 36


Differential 6

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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

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Arm’s Length Contracts

Recall: Nature of contract is dependent on resource and industry

1. Price paid:Zinc: $1.02/lb x 2 204.6 = $2 250 /MT (average LME spot price)Silver: $17.00 / oz

2. Expected value of resource realized by processingZinc: 55% x 85% = 46.75% x $2 250 = $1 051.88Silver: (5oz – 3oz) x 70% x $17.00 = 23.80 Total Payable = $1 075.68

3. Processing deductionsProcessing Costs: Base fee = $275.00Adjust for price change: $2 250 – 2 500 = 250 x 4C/1$ = $ 10.00Penalty for Fe 8.5% - 8% = 0.5% x $1.50 $/1% = (0.75)Penalty for MgO 0.5% - 0.35% = .015% x 2.00 $/0.1% = (3.00)Total deductions = (268.75)

Paid to mine = $ 806.93Percentage realized by mine = 75%

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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)

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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

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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

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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

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Canadian Resources

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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

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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

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‘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

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Case Studies

Commodity marketing (1) – Related marketer

Commodity marketing (2) – Functional deficiency

Commodity marketing (3) – Financial transactions

Business restructuring / expansion

Mining and intangibles

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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

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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

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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

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Case Study 1: Related Party Marketer

Mineral SalesCANUS

CANCOMining and Processing

USCOParent

US Distribution

Mine 2

Mine 3

Mine 1

3rdParties

3rdParties

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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

Percentage return 91.70% 85.20% 70.00%

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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

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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

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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

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‘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

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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

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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

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Commission fee Implied by Berry ratio analysis:

Recall Taxpayer commission fee:

Jun-01 Dec-01 Dec-02Third party freight and logistical

3.35 3.34 3.43

SG&A 7.65 7.54 6.56Total Cost per ST 11.00 10.88 9.99

Commission Rate implied by CRA methodology

13.25 12.91 11.99

Mark-up 2.25 2.03 2.00Percentage return 20.45% 18.66% 20.02%

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 11.00 10.88 9.99

Commission Rate 21.09 18.50 18.50

Mark-up 10.09 7.77 8.51

Percentage return

91.70% 85.20% 70.00%

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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

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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

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Case Study 2: Functionally Deficient Marketer

Sale of

resource 100% CANNetback

price USCO 'outsource' marketing USfunctions to CANCO marketingdivision

CANCO

USCO Marketer

OPCO(Marketing office)

3rd Party Co-Gen

Plant

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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

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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

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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

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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

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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


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

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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

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(1) Guarantee (2) Guarantee

100% CAN

US

Sells Gas (25% + 75%) Sells/transports 75% of gas

(4) Agreement totransport 25% of gas

100% (3) Guarantee

Sells 25% of gas

CANCO

USCO*

Parent

GASCO1

GASCO2

TransCO

End Users

OPCO

52


Taxpayer position:

Reasonable to ‘outsource’ functions

Key profit drivers: right to deliver and sell gas

USCO exploited ‘arbitrage’ opportunities

53


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

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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

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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

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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

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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

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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

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Sale of

resource 100% CANNetback

price USCO 'outsource' marketing USfunctions to CANCO marketing

division

The marketers 'trade' supply to reduce transport costs

Creates gains and losses

CANCO

USCO Marketer

OPCO(Marketing office)

3rd Party Marketer

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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

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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

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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


Canada secures contractProvision sells drills and trains of drilling employeesservices

PortCo

Private Owners

CANCOParent and Operating Company

InternationalDrilling

(CANCO)

64


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


A variation:

CAN Canada secures contract Luxembourg sells drills

Provisionof drilling services

Employeetraining

PortCo

Private Owners

CANCOParent and Operating Company

InternationalDrilling

(CANCO)

LuxCo

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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

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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

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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

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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’

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Q: Is a royalty payment reasonable?

A: It depends

Fundamental considerations

• Diffusion of technological know-how

• In-house skilled personnel

• Cost and financing

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Diffusion of Technology

• CANCO used technology for 30+ years

• Expired patents

Personnel

• CAN involved in development

• CAN responsible for enhancements

Cost

• ?

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Case Study 5: Technology Royalty (cont’d)Example (cont’d)

Challenged

• Reasonableness of payment

• Duration of agreements

• Economic circumstances

Favourable conclusion achieved – just about

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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

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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

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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

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¿Preguntas?

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

Documents

expected market pricing

price demand

pricing issue slide

price of inputs

gas slide

availability slide

functions slide

paradox of value slide