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Transfer Pricing Considerations for Government Subsidies (CEWS)

Transfer pricing considerations if your business has applied or is applying for Government subsidies such as Canada Emergency Wage Subsidy (“CEWS”) in the context of COVID-19.

  • As of September 30, 2020, over 1 million Canadian employers have applied for the Canada Emergency Wage Subsidy (“CEWS”), where corporations were adversely affected by COVID-19 pandemic, therefore significantly reducing their revenues since March 2020. The Government provided specific eligibility criteria for corporations to apply for the CEWS, including those where a large portion of the revenues are derived from sales to a related, non-resident, who might then sells to third parties.
  • Specific transfer pricing implications arise in the context of Government subsidies such as CEWS. For example, one way that taxpayers could manage the pandemic’s adverse impact on their businesses is by including or sharing all or part of the COVID-19 government assistance with a related non-resident. This could take the form of reducing allocable costs for mark-up. However, the Canada Revenue Agency (“CRA”) has not specifically addressed this in the Transfer Pricing Memorandum-17 (TPM-17 was published in March 2016)

  • According to TPM-17, when a taxpayer receives governmental subsidies and uses a cost-based transfer pricing methodology to determine the transfer price of goods, services, or intangibles sold to a related non-resident, the cost base should not be reduced by the amount of the government assistance received. The only exception to this guidance is that there should be reliable evidence that arm’s length parties (independent third parties) would have contracted similarly given the specific facts and circumstances. The CRA has confirmed that its position has not changed because of the COVID-19 pandemic at a roundtable held on September 15 by the Canadian branch of the International Fiscal Association (IFA).

  • The CRA expects the temporary assistance provided to Canadian taxpayers to remain in Canada, and should not be used to reduce the transfer prices charged to foreign entities. There are no specific examples provided in the context of market-based comparable data that CRA will expect or accept from a taxpayer that decides to offset its costs against the assistance received in determining its transfer prices. As a result, it seems that it will be challenging for a Canadian taxpayer that receives the CEWS or other COVID-19-related government assistance to substantiate a reduction in the inter-company price(s) charged to a related non-resident.

  • As a practical next step, affected taxpayers should undertake an arm’s length analysis to demonstrate that the prices charged reflect arm’s length prices and are not merely an application of a cost-plus formula. This will take the form of an up-to-date arm’s length analysis prepared by the taxpayer to determine if a reduction to the inter-company price reflects market rates and the cost base is not reduced by the Government subsidy received. Furthermore, the outcome of such analysis and resulting positions adopted must be documented accordingly. The absence of supporting information will likely result in penalties and potentially increase the taxpayer’s income tax obligations in Canada. Considering TPM-17 does not provide clarity on reliable evidence, and there is no precedent on demonstrating that the cost-base used for transfer pricing purposes should be reduced by the amount of Government assistance received, having supporting documentation to prove that arm’s length (independent) parties would transact similarly, becomes critical.

For further information or any assistance you require on your cross-border inter-company arrangements, contact our Transfer Pricing Principal & Practice Leader Avinash S. Tukrel.

Announcing our New Service Line: Outsourced Accounting Services

Segal LLP is pleased to announce the launch of our full suite of bookkeeping and cloud accounting services. Our team provides a comprehensive and customized approach to deliver reliable advice and practical solutions to clients.

Our advisory teams will support clients in managing the critical on-going functions of their business. Clients will find balance and peace of mind having their day-to-day financial administration processes guided by our diverse and skilled team of professionals.

With access to leading cloud-based technology, our team supports organizations to manage their financials in a streamlined and cost-effective one-stop hub.

Benefits of Segal’s Cloud-Based Financial Reporting Services:

Bookkeeping
  • Full Cycle Bookkeeping
  • Accounts Receivable and Accounts Payable
  • Cash Receipts
  • Payroll Processing and T4s
  • Government Remittances
  • Bank Reconciliation
  • General Monthly Reporting
Accounting Management
  • Assist in the setup of digital accounting files and accounting databases
  • Accounting program conversion to QuickBooks Online (QBO)
  • Train client staff on QBO, accounting processes, and additional applications
  • Clean up and catchup of accounting books
Consulting
  • Liaison with year-end accountant on financials
  • General business financial consulting
  • Cash management assistance
  • Business plans and budgeting
  • Accounting department process reviews
Virtual Assistant Work
  • Data processing and maintenance of databases
  • Power Point Presentation Creation
  • Project Research
  • Staff employment assistance such as reference and background checks

Our clients will draw on more than 50 years of combined industry experience, with professionals providing insight into managing risk, growth, and profitability.

Contact us to learn more!

Employee Home Office Expenses – Update

In light of Covid-19 many employees have been required to work from home for a large portion of the 2020 calendar year.  As such, new streamlined rules apply for the 2020 taxation year that will allow individuals working from home to claim home office expenses on their personal income tax return.

New Temporary Flat Rate Method

If an individual worked from home 50% of the time for a period of at least four consecutive weeks, the individual is eligible to use this new method.

This new method will allow the individual to claim $2 per day for each day the individual worked from home during the period.  In addition, the individual can claim an additional $2 per day for each additional day that was spent working from home.

The maximum under this method is $400 per individual.

If there are multiple people working from home, each individual can claim up to $400, under this method.

This method does not require the individual to support the home office expenses by calculating square footage of workspace.  In addition, the individual is not required to maintain receipts for home office related expenses. 

Detailed Method

The detailed method will allow an individual to claim specific home office related expenses incurred during the time an individual worked from home.

To be eligible, the CRA provides the following criteria on their website:

  • The individual worked from home in 2020 due to Covid-19 OR was required to work from home by their employer;
  • The individual worked more than 50% of the time from home for a period of at least four consecutive weeks in 2020;
  • The individual has a signed Form T2200S or Form T2200 from their employer; AND
  • The expenses incurred directly in the individuals work during the period.

Form T2200S is a new prescribed form applicable only to those employees that worked from home due to Covid-19 in 2020.  The form must be completed and signed by the individual and their employer, but, the individual is not required to remit the form to the CRA.  The individual is required to retain the signed form in the event the CRA requests a copy.

If the employee is required to pay for employment expenses other than home office expenses, Form T2200 should be used instead.

Common Issues in Waterfall Calculations in Commercial Real Estate

Real Estate Professionals (the “Sponsor”) commonly create Real Estate LP/GP Structures as a tool to facilitate the acquisition of real estate assets and structure these acquisitions with multiple investors.  These structures provide investors (“Investor”) with an opportunity to invest in large real estate acquisitions that they may otherwise do on their own.  The Sponsors leverage this tool to raise capital for purposes of acquiring real estate assets they have identified.  In order to compensate both Investor and Sponsors equity waterfall calculations are incorporated in Limited Partnership Agreements (“LPA’s”).

Real Estate Waterfall models in commercial real estate deals are one of the most challenging concepts to understand when dealing with cash flow distributions.  The Waterfall is the approach for splitting free cash flow among Investor and Sponsor in a real estate investment that allows for uneven distributions.  This type of planning provides an incentive bonus to the Sponsor to participate in a disproportionate share of the returns.  This bonus is often called ‘the promote’.

The Waterfall model typically includes a preferred return and a return hurdle rate.  Internal Rate of Return (IRR) is commonly used as the hurdle rate.  IRR is a metric that identifies to an investor the average annual compounded return they have realized from a real estate investment over time, expressed as a percentage.

The preferred return is the first claim on free cash flow distributions.  Once the preferred return, expressed as a percentage, is achieved then any excess free cash flow is split as agreed.  The LPA will also deal with the following elements for the preferred return model.

  • Which equity investors receive the preferred return?
  • Is the preferred return cumulative?
  • Is the preferred return compounded and at what frequency?

The Business Deal

A real estate investment opportunity may include a waterfall calculation that provides the Limited Partner with a cumulative rate of return (“Preferred Return”) equal to a nominal annual rate of 7% per annum compounded semi-annually on invested capital.  After the 7% preferred return has been achieved, all additional cash flow distributions up to a15% IRR will be allocated at a proportion  of 25% to the General Partner and 75% of the Limited Partner.  After a 15% IRR hurdle has been achieved, all additional cash flow distributions will be allocated at a rate of 50% to the General Partner and 50% to the Limited Partners.

Common Issues

Model Frequency

LPA’s will often specify when capital contributions are deemed to be made.  Most commonly this will be stated as the actual day of activity.  This becomes important when determining the amount of preferred return attributable to a capital contribution when the preferred return is expressed using an annual rate.

Let’s determine the preferred return on a $100,000 capital contribution made on January 1, 2021 and subsequently distributed on August 1, 2021.  If we simply took the number of days the contribution was outstanding and prorated over 365 days, we would calculate the preferred return to be $4,085.  Using XIRR function in excel this preferred payment provides an XIRR of 7.14% which is higher than the required rate of return of 7%.  However, if we applied a more accurate rate of return formula using (1 + Rate) ^ (number of days / 365) we would calculate a preferred return of $4,008.  The use of this approach prevents an overpayment of preferred return by 1.92%.

Hurdle Rate Compounding

The compounding period for the hurdle rate will also affect the calculation of the effective rate of interest.  In the above example the nominal 7% preferred return compounded semi-annual equates to an effective annual interest rate of 7.12%.  If only the nominal rate of return is used, then the preferred return per annum would be understated by $120 per annum.

Calculating the accrued preferred return on initial capital contributions

The preferred return is calculated on the initial capital contributions using the preferred rate of return outlined in the LPA.  The preferred return may either be calculated on a cumulative or noncumulative basis.  A preferred return calculated on a cumulative basis is added to the initial capital contributed.  Distributions are deducted from the cumulative preferred return earned.  The LPA needs to clearly specify what events can cause the initial capital contribution to be reduced.  These events are typically restricted to the sale of the real estate asset or refinancing.  Under these circumstances the preferred return earned in the current period cannot be reduced if the previous periods distributions exceed the preferred return.  If the initial investment was $100,000, for 90% of the equity, with a preferred return of 7% in year(s) 1 to 5, the real estate investment returns $10,000 per year.  If the preferred return is calculated assuming that cash flow distributions in excess of the preferred return are a reduction to the initial capital contribution instead of a distribution, it is subjected to a waterfall calculation.  This may cause an overstatement of distributions to the initial capital contribution.  Over a 5-year period this overstatement will be $2,252 or 4.46% of the total distributions.

Understanding the economic terms of a real estate transaction are critically important in ensuring that returns to investors are consistent and correctly calculated in accordance with the LPA and the marketing materials that may been shared with the investors.

Written by Segal LLP Managing Partner, Dan Natale CPA, CA.

Partnership Announcement

Segal LLP is pleased to announce the firm’s two new partners.

Candy Hsieh, CPA, CA, and Jason Montgomery, CPA, CA, have joined the firm’s partnership group, effective January 1st, 2021.

Candy Hsieh joined Segal in October of 2006. She plays an integral part of Segal’s assurance and advisory practice. She has extensive experience in providing clients with tax planning and leading audit, review and compilation engagements across  a multitude of industries including owner-managed companies, non-resident corporations with subsidiaries in Canada, private equity groups, real estate, financial services and professional services.

Candy is a dedicated client service professional who provides her clients with results that are both strategic and practical when requested to assist in their personal and financial matters. Her strong analytical, business and tax skills together with a consistent collaborative approach has enabled her clients to achieve their goals. She has earned her clients’ appreciation for protecting their assets and minimizing their taxes.

Jason Montgomery began his career at Segal in 2004 as the firm’s first ever co-operative education student out of Wilfrid Laurier University, where he graduated from the Honours Bachelor of Business Administration program (2006).

Jason is a trusted advisor at Segal LLP as part of Segal’s assurance and advisory practice.  He is responsible for delivering exceptional service to clients across various industries including retail, wholesale/distribution, financial and professional services, information technology, construction, real estate and not-for-profit.  Clients appreciate his insight into their financial results and his help with advising on tax matters.

We extend our sincere congratulations to both Candy and Jason and welcome them to the Segal partner group.

Candy Hsieh

416-774-2486
chsieh@segalllp.com

Jason Montgomery

416-774 2487
jmontgomery@segalllp.com