The concept of transfer pricing, or more specifically the standardization of transfer prices assigned to intercompany transactions or transactions executed within a related group, becomes ever more relevant with the growth of worldwide commerce and the movement of products, services, workers and firms across jurisdictional boundaries. Transfer pricing contemplates not only the movement of tangible goods but also the assignment of value from internal services to various stages of production.
As entities grow, they may encounter a myriad of conflicting interests and decisions in arriving at appropriate transfer pricing. Some conflict may be altruistic in nature, an unavoidable consequence of attempting to arrive at a fair valuation of intangible inputs such as human investment in and opportunity cost of different stages. Uncertainty can also arise where an individual unit’s objectives stray from the common benefit to serve a self-interest.
Achieving a common understanding between the related group as to how goods and services are internally transferred is unquestionably a benefit. It helps everyone more accurately measure performance by unit, seek opportunities for improved efficiency, and properly acknowledge key contributors. The value of this information, however, is not always commensurate to the time, effort and resources necessary to compile it thoroughly and accurately. Overriding all this could be the motivation to minimize tax liability.
Looking over the shoulder of affected related entities are competing tax jurisdictions. Pursuit of funds held across borders as a means of reducing tax have become a priority as governments seek opportunities to increase revenues through new avenues. The increasing popularity of e-commerce has prompted many governments to revise statutes pertaining to the collection of state sales tax by vendors with no traditional establishment in the jurisdiction (for example, the province of Quebec, as well as several US states). Indeed, competition for sales tax collection revenues appears to be intensifying no differently than it is for those arising from the traditional sale of goods and services.
In Canada, penalties assessed by CRA related to inappropriate transfer pricing have been on the rise. The implication of this is two-fold. First, it suggests that instances of investigation of transactions of this nature have become a greater priority. Second, the standard to which CRA scrutinizes such transactions may be very aggressive. A presumption of the taxpayer’s bias towards tax minimization likely exists, placing additional, perhaps undue, onus on the entity to demonstrate appropriate steps taken to assign fair pricing and allocation of profit across jurisdictions.
When dealing with taxation authorities, there will always be uncertainty regarding planning. Thorough preparation and awareness of the issue, however, can provide some protection if inquiry or audit should arise, and improve the chances of a favourable outcome.
The standard of what CRA might require is somewhat vague as presented, leaving open the opportunity for interpretation. For tax purposes, transactions are required to adhere to the arm’s length principle, that is, transactions between related parties are required to mirror in valuation those between parties where such influence is not present. Where an outside market for the transactions in question does not in the normal course of business exist, complications arise.
Canada’s transfer pricing rules apply when:
• Two or more entities are involved
• At least one of the entities is a taxpayer for Canadian 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 arm’s length and
• The parties enter into a transaction or series of transactions
If questioned, the responsibility will fall on the Canadian entity to demonstrate compliance with the arm’s length principle. To facilitate this, a detailed transfer pricing agreement between the transacting parties can not only ensure preparedness to respond promptly to such queries but also provide a compelling piece of evidence of intent to comply with the requirement.
Guidance on the content of a transfer pricing agreement is somewhat subjective. However the more detail included and points stipulated to by the transacting parties can demonstrate a depth of analysis more likely to satisfy an auditor that proper steps were taken towards ensuring compliance. Further, any potentially contentious considerations employed in arriving at fair pricing may be viewed more favourably if forming part of a standard contract with stipulated business rationale, prepared without prompting, than if done only in response to audit.
Consider also the frequency with which such agreements should be drafted, reviewed and revised. It is recommended that where transaction volumes are high, transfer pricing agreements are revisited at least annually, for three primary reasons. One, an entity’s circumstances and indeed costs may change significantly from year to year. Two, CRA retains the right to audit for a period of seven years, and where circumstances have changed over time the ability to retroactively produce compelling evidence of particular business conditions will naturally diminish over time. Three, the ability to demonstrate to an auditor a consistent approach to transfer price determination when warranted coupled with a timely response to changing circumstances when appropriate may lend credibility to positions more reliant on judgment than firm calculations.
A final consideration is that jurisdictions other than Canada similarly have the right to audit these same transactions according to their own criteria. Therefore, biasing such an agreement in such a way as to solely appease domestic authorities is unwise. The objective should therefore be to truly arrive at an appropriate allocation of costs and profit across all impacted jurisdictions so as to have comfort that the group’s position could withstand scrutiny uniformly. It is prudent to note that any detrimental adjustment mandated by one jurisdiction would not result in a corresponding favourable adjustment in another, therefore exposing the group to double taxation, the remedy to which would be costly and time consuming, in addition to any penalties assessed by the auditor.
Implementing a proper transfer pricing agreement is no small undertaking to be certain, though the benefits of such an investment are evident. In light of recent trends, such a proactive demonstration of an attitude of compliance may be invaluable should the need arise.