Transfer Pricing

Corporations that carry out significant transactions with foreign corporations under common control cannot avoid the question of transfer pricing because it encompasses tax compliance, risk management and international tax planning.

The issue of transfer pricing is constantly evolving in Canada and internationally, particularly as a result of the Organisation for Economic Co-operation and Development’s (“OECD”) base erosion and profit shifting (“BEPS”) project. Being aware of transfer pricing rules and applying them correctly is therefore crucial.

Transfer pricing rules in Canada

Generally, in Canada, transfer pricing is governed by Section 247 of the Income Tax Act (“ITA”). The Canada Revenue Agency (“CRA”) generally refers to the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations in applying transfer pricing rules.

The underlying rule in Canada is the arm’s length principle, which Canadian residents must apply for transactions with non-arm’s length non-resident parties. This principle requires that arrangements between the non-arm’s length parties be the same as those with arm’s length parties in similar circumstances. under this principle, Canadian residents involved in cross-border transactions with non-arm’s length parties should report essentially the same income as they would have with arm’s length parties.

If the CRA considers that the arm’s length principles is not applied, it can adjust the transfer prices and impose a penalty. The penalty could apply if total CRA upward adjustments (capital and income) are greater than $5,000,000 or 10% of the entity’s gross income and will be 10% of the adjusted amount. This penalty can, however, be avoided if the taxpayer is able to demonstrate that it has made reasonable efforts to determine and use arm’s length transfer prices.

Reasonable efforts by the taxpayer can be demonstrated if the taxpayer has maintained transfer pricing documentations that complies with ITA 247(4). It must provide this documentation within three months of receipt of a CRA request. In addition, such documentation must be timely, i.e., prepared or obtained on or before the filing deadline for the taxpayer’s tax returns for the tax year in which the transaction was entered into.

Audit

As part of a tax audit, the CRA will request transfer pricing documentation at an early stage of the process. This request will be made in writing and the taxpayer will have 90 days to provide the documentation. If documentation is not provided, the taxpayer has no protection against the transfer pricing penalty. The absence of documentation also shifts the burden of proof to the taxpayer.

It should be noted that the limitation period for a transfer pricing audit in Canada is three years longer than the usual period, and can therefore extend up to seven years.
In the event that a taxpayer is issued a transfer pricing adjustment, the taxpayer has 90 days following receipt of a reassessment to file a notice of objection. This notice of objection is necessary to protect the taxpayer’s right of appeal to the CRA’s Appeals Branch and to the Canadian courts.

In the event that the transfer pricing adjustment is upheld, the taxpayer will be in a situation of double taxation, as taxes will have already been paid on the income in the foreign country. The taxpayer will be able to seek assistance from the appropriate Canadian and foreign authorities to avoid double taxation if the tax treaty between the two jurisdictions provides for such a mechanism.

It’s important to note that the CRA is one of the most aggressive tax authorities in the world when it comes to auditing transfer pricing. Unlike its U.S. counterpart, the CRA audits medium and large corporations and is prepared to issue a notice of reassessment for amounts as little a few hundred thousand dollars.

These audits have resulted in taxpayers spending considerable time and money objecting to the notices of reassessment, requesting the assistance of the appropriate Canadian and foreign authorities to avoid double taxation and appealing decisions in Canadian courts. In many cases, this could have been avoided had the transfer prices been properly determined and documented. Having well-prepared documentation with all the necessary supporting documents often determines the parameters considered during an audit.

Corporations subject to applying transfer pricing rules are legally obligated to document their intercompany transactions. Missing documentation translates into a significantly higher risk of a reassessment, non-deductible penalties and interest payable in unpaid taxes. However, transfer pricing rules also provide all of the requisite tools to efficiently manage a multinational’s international tax burden. Transfer pricing rules should be known and applied.

Don’t hesitate to call on your Raymond Chabot Grant Thornton advisor who can help answer your transfer pricing questions.