OECD Presentation Resources and Transfer Pricing: A Canadian Perspective

1. OECD PresentationResources and Transfer Pricing: A Canadian Perspective San 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

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

7. Mineral Extraction: Stages and Functions

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. 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. 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. Level of Market and Pricing Issue

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. Resource Value Chain and Transfer Pricing • Mining • Oil and Gas

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. 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. 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. 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. 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. 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 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: $2 250 – 2 500 = 250 x 4C/1$ = $ 10.00 Penalty 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 = $ 806.93 Percentage realized by mine = 75%

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. 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 • Industryand market value chain • Note: Oil and gas markets have changed significantly since the 1980s

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. 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. Canadian Resources

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

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. 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. 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. Case Study 1: Related Party Marketer

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

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. 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

43. Case Study 2: Functionally Deficient Marketer

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. 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. 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. 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. 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. 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. 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