What Businesses Should Know About Transfer Pricing

A border bridge between Canada and the US in Niagara Falls, Ontario

What is ‘Transfer Pricing’?

What is meant by the term Transfer Pricing? Does it apply to all companies or only some? It applies to multinational enterprises (MNES) that buy and sell products and services between their inter-jurisdictional divisions. The big reason for a focus on transfer pricing is that MNEs can be fined taxes and penalties if one division sells products to another division at too high or too low a price. If the division selling the goods is in a country where the corporate tax rates are lower than the country of the buying division, a higher than normal selling price would generate more profit in the lower-taxed division.

What is an ‘Arms-Length’ Transaction?

The Organization for Economic Cooperation and Development (OECD) was created in 1961 to help fight this battle of pricing manipulation. It has 37 member companies.

The main principle that OECD operates under is called “arms-length”. An arms-length transaction happens when goods or services are bought and sold between two independent parties that are not related in any way. This is the standard by which a transfer between subsidiaries will be judged, as the pricing should be the same as if the entities were unrelated. If the tax authorities in one country can prove that intercompany goods have been sold between two divisions of an international conglomerate at a price that does not represent an arms-length transaction, taxes and penalties will be levied to bring this price to be what is best estimated to be equal to an arms-length transaction.

Canadian Transfer Pricing Rules

What are the rules regarding transfer pricing from a Canadian Standpoint? As per the Canada Revenue Agency (CRA), Canada’s transfer pricing rules apply if:

  • two or more entities are involved;
  • at least one of the entities is a taxpayer for Canadian tax purposes (an entity can be non-resident but still be a taxpayer for Canadian income tax purposes);
  • it is a cross-border transaction involving Canada;
  • the Canadian taxpayer and at least one of the offshore parties are not dealing at arms-length; and
  • the parties enter into a transaction or series of transactions.

Further, quoting CRA documentation “[a company] must keep all records of non-arms-length transactions with non-residents. [A company is] not considered to have made ‘reasonable efforts’ to determine and use arms-length transfer prices unless [it] compile[s] certain information, known as contemporaneous documentation. See TPM-05R.”

As well, the due date to prepare or obtain contemporaneous documentation is the filing-due date for the corporation, trust, individual or partnership’s tax return. However, the contemporaneous documentation should not be included with a business’s return. The CRA will request it via a written request, served personally by registered or certified mail and the request is required to be satisfied within three months.

From a penalty standpoint, the Income Tax Act allows the CRA to adjust a Canadian taxpayer’s transfer prices or cost allocations if they do not reflect arms-length terms and conditions. Should the CRA adjust your business’s transfer prices, you may be subject to penalties if you did not make reasonable efforts to determine and use arms-length transfer prices. The transfer pricing penalty is equal to 10% of certain adjustments made under the Income Tax Act. It strongly recommends that you make your financial decisions clear to the CRA to reduce the risk of potential interest and penalties by clearly documenting compliance with the arms-length principle.

Minimizing Risk

What can an MNE do to minimize the impact of being audited by tax authorities for inappropriate transfer prices? As well, is there a perfect arms-length transfer price for every transaction? There are 5 methods of calculating divisional transfer prices that are accepted by the OECD:

  • Comparable Uncontrolled Price (CUP) method
  • Resale price method
  • Cost Plus Method
  • Transactional Net Margin Method
  • Transactional Profit Split

An experienced financial consultant/accountant familiar with cross-border tax matters will work with you to determine the best method for calculating and setting transfer pricing for various transactions and ensure your business is in compliance. This is key to avoid surprise penalties and audits down the road.

COVID-19 Implications

Despite ongoing border closures, the governments of both Canada and the US are continuing to allow the flow of goods and essential services across the border to maintain supply chains. As we are going through very different business situations and conditions due to the virus conditions, it is important that your transfer pricing policies are reviewed and adjusted as necessary.

If after reading this blog, you wish to get more familiar with transfer pricing conditions and need assistance in reviewing your transfer pricing policies, the accounting professionals at Edelkoort Smethurst Schein CPAs LLP can assist you. We assist clients from single freelancers to large organizations with the management and remittance of these deductions and will ensure that you are fully compliant from the start. To speak with one of our experienced accountants about managing or advising on your business’s accounting needs, please contact us by phone at 905-517-2297 or fill out our online contact form.