Transfer pricing: Common questions and answers
Since the introduction of Canada’s transfer pricing rules in 1998, we’ve seen the CCRA significantly increase their focus (and audit attention) on international related-party transactions. As a result, we’ve been receiving an increasing number of transfer pricing questions from taxpayers. A summary of some of the more common questions and our answers are noted in this document. These are only intended as a guide-specific questions should be addressed to your local tax practitioner.
Q. We hear a lot about transfer pricing. What transactions are covered?
A. Transfer pricing is the methodology used to determine a range of acceptable, market-orientated prices for cross-border, related-party transactions. Such transactions may involve goods, services, intellectual property (intangibles), or funds transferred within a related group.
The Canadian transfer pricing rules incorporate the arm’s-length principle for all cross-border, related-party transactions. In other words, the terms and conditions, including price, should approximate as closely as possible the terms that would have been negotiated if the two parties were dealing at arms length.
Q. Why should we be concerned about tranfer pricing? Our company has been through audits before, and the CCRA has never proposed any adjustments to our transfer prices.
A. In the past, your company may have been visited by a single auditor responsible for reviewing all tax matters. The CCRA has re-engineered its approach and today has dedicated international auditors whose sole responsibility is to examine and audit a company’s international transactions. In our experience, when taxpayers fail to assemble proper documentation prior to an audit, the time, effort, and cost to compile the information requested by the CCRA is significantly more onerous.
The transfer pricing legislation, combined with the CCRA!s guidance in Information Circular 87-2R, has established the minimum standard for taxpayer compliance in the area of transfer pricing.
Q. What is contemporaneous documentation?
A. The term “contemporaneous documentation” refers to the documentation requirements outlined in subsection 247(4) of the Canadian Income Tax Act. The subsection requires taxpayers to maintain detailed information regarding transactions with related parties, which should be updated on an annual basis. This documentation should explain the business context in which the related-party transactions take place and provide the taxpayer with the opportunity to justify and support the basis of pricing used.
The legislation requires that the documentation include:
a description of the transaction (the property or service being transacted, the terms and conditions of the transactions, and the identity and relationship of the transacting parties);
an analysis of the functions performed, risks assumed, and assets utilized by the parties;
an evaluation of the possible transfer pricing methods, an assessment of relevant data and justification for the transfer pricing method selected; and
details of any assumptions, strategies, and special circumstances (such as a market penetration strategy) that have influenced the pricing analysis.
Q. What happens if we don’t have documentation in place to support our transfer pricing?
A. Your documentation is one of the first sources of information the CCRA international auditor will use to gain an understanding of your business, the particular circumstances in which you operate, and the appropriateness of your transfer pricing. From our experience, the CCRA is much more likely to propose a transfer pricing adjustment in cases where a taxpayer’s documentation is incomplete or inaccurate.
In addition, without contemporaneous documentation, the CCRA may conclude that you have not made reasonable efforts to support your transfer pricing, and the following are some of the many negative consequences that may result:
A penalty of 10% of the value of any transfer pricing adjustments may be imposed, subject to a minimum threshold;
Offsetting adjustments (which would reduce the amount of additional income) may not be allowed;
The audit is likely to be more extensive and take longer to complete;
The CCRA may prepare its own transfer pricing analysis. The onus is then on you to shift the CCRA from the position adopted; and
The CCRA may seek to use “secret comparables” when proposing transfer pricing adjustments.
Q. Our parent company in the US had a transfer pricing report prepared by their US advisors. May we use their report for Canadian tax purposes to fulfill the contemporaneous documentation requirements?
A. Not necessarily. In some instances, the IRS and the CCRA’s rules regarding transfer pricing are similar; for example, both jurisdictions require related parties to transact with each other on an arm’s-length basis. However, there are some significant differences between the Canadian and US rules, which means that documentation prepared by your US parent company will not necessarily satisfy the CCRA. For instance, in selecting an appropriate transfer pricing methodology, the IRS requires that the “best method” be used to establish a transfer price. All transfer pricing methods must therefore be evaluated.
According to the CCRA, there is a natural hierarchy of methods; in general, taxpayers are expected to follow this hierarchy when selecting the appropriate method.
In addition, a transfer pricing report prepared for the US parent may focus on demonstrating that the US company is compensated for transactions with its Canadian subsidiary at least at an arms-length amount. This may be satisfactory from the IRS perspective, but the CCRA will require evidence that the Canadian company is not paying too much for these intragroup transactions.
Q. I don’t think we need a report. We charge our US parent company the same price we charge some ofour customers.
A. The CCRA requires that taxpayers exercise judgement in determining the degree of transaction comparability. Here are some of the factors that should be considered:
the characteristics of the property or services being purchased or sold;
the functions performed by the parties to the transactions (taking into account assets used and risks assumed);
the terms and conditions of the contracts, including areas such as warranties;
the economic circumstances of the parties, such as market level (wholesaler or retailer) and transaction volumes; and
the business strategies pursued by the parties.
The price charged to other customers may be a useful starting point when determining the transfer price for transactions with a foreign parent. However, the CCRA will require documented support for a sufficient degree of comparability (contemporaneous documentation) before accepting the appropriateness of this pricing method.
For example, are the volumes sold to your US parent and to unrelated parties comparable? Are these unrelated parties also based in the US and operating at the same market level as your US parent? Are the terms and conditions offered to your US parent similar to those offered to the unrelated parties?
Q. What if the IRS proposes a transfer pricing adjustment to our US-related company? Presumably we can just adjust our Canadian tax returns to reflect this position?
A. Unfortunately the answer is no. When the IRS makes a transfer pricing adjustment to a US taxpayer’s return, the CCRA does not automatically allow a corresponding adjustment to be made to the Canadian– related party’s return. Similarly, when the CCRA makes a transfer pricing adjustment, the IRS does not automatically allow a corresponding adjustment to be made to the US taxpayer’s return. Income may therefore be taxed in both jurisdictions.
Taxpayers may, however, obtain relief under the Mutual Agreement Article of Canada’s bilateral income tax treaties through the competent authority process. But note: In our experience, this process can be both lengthy and costly.
By Gordon Denusik, CA, and Michael Glaser, CA
CAs Gordon Denusik and Michael Glaser are Senior Managers, Transfer Pricing in the International Tax Group of KPMG LLP in Vancouver.
Copyright Institute of Chartered Accountants of British Columbia Oct 2002
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