Transfer Prices: Minimise your Taxable Income and Remain Compliant

Transfer prices are used by related companies to determine the amounts by which intercompany transactions are recognized for accounting and tax purposes. The transaction may include the transfer of goods, services and/or intellectual property.

In the case of cross-border related-party transactions, tax authorities often view transfer pricing as a mechanism by which profits may be shifted between legal entities for purposes of minimiszing taxable income within the consolidated entity. Tax authorities frequently review these transactions to ensure that their jurisdiction receives an appropriate share of the overall corporate profitability and the resulting tax revenue. Each tax jurisdiction strives to protect its tax base by requiring that transfer prices reflect arm’s length terms and conditions. Also, most tax authorities, including Canada and the U.S., require that transfer-pricing transactions be documented annually. Failure to do so can create substantial penalties for non-compliance. By the same token, sound transfer-pricing planning can considerably reduce tax liabilities by taking advantage of differentials in tax rates among the relevant jurisdictions and by eliminating certain tax inefficiencies.

Canadian compliance requirements: Section 247 of the Income Tax Act specifically addresses transfer pricing. Information Circular 87-2R provides guidance with respect to the application of the legislation. The Act specifies six areas to be documented, as illustrated in Figure 1. If an adjustment on a related-party transaction reaches a certain threshold, a taxpayer is subject to a penalty if:

• the transaction was not documented in a complete and accurate manner;
• the documentation was not completed within six months of the fiscal year the transaction occurred; or
• the documentation was not given to the CCRA within 90 days of their request.

1. What is the transaction? This requires a description that is complete and accurate in all material respects of the property or services to which the transaction relates. You need to prepare a detailed description of the type of property or service that is being transferred.
2. What are the prices, terms and conditions of the transactions? This requires a description that is complete and accurate in all material respects of the terms and conditions of the transaction and their relationship, if any, to the terms and conditions of each other transaction entered into between the persons or partnerships involved in the transaction. The description should also include: the volume, the frequency and currency of the transactions, as well as how the transactions are financed and the point of ownership transfer.
3. Who are the participants to the transaction? This requires a description that is complete and accurate in all material respects of the identity of the people or partnerships involved in the transaction and their relationship at the time the transaction was entered into.

Note: The first three requirements contain the background information on the transaction. These three requirements are easy to fulfill, as they involve only the basic information about the transaction. The last three requirements require significant time and effort to fulfill.

4. What functions are performed, properties contributed, and risks held by the parties? This requires a description that is complete and accurate in all material respects of the functions performed, the property used or contributed, and the risks assumed by the people or partnerships involved in the transaction. This requirement is generally referred to as the functional or process analysis.

In simple terms, this section describes what each party brings to the table and provides the basis for determining the appropriateness of the transfer prices. The analysis often identifies the nature and extent of any intangibles that may be inherent in the transaction. This analysis also addresses the relative contributions of each party to the transaction and identifies and evaluates the commercial risks incurred by each of the parties.

5. How is the price calculated and why is the price arm’s length? This requires a description that is complete and accurate in all material respects of the data and methods considered and the analysis performed to determine the transfer prices or the allocations of profits or losses or contributions to costs, as the case may be, for the transaction.

This section includes:

• a description of the comparable transactions considered and of those used in applying the pricing method;
• an assessment of the degree of comparability of such transactions with the taxpayer’s transactions, and
• a description of any adjustments made to enhance the degree of comparability.

Where the taxpayer considers more than one method, this also includes the analysis performed using each of those methods, as well as the analysis that led to the selection of the chosen method. This requirement is generally referred to as the economic analysis. It supports the arm’s-length basis of the price, terms and conditions of the transactions.

In Canada and most other OECD countries, several methods are available to demonstrate that a transaction meets the arm’s-length principle. The most persuasive methodology is the comparable uncontrolled price method, or CUP. The CUP method compares a similar price or transaction that one of the parties has had with a non-related party to that of the related-party transaction. The other accepted methods test the margins and profits earned by one or both of the participants in the transaction. The information gathered in the fourth requirement forms the basis to determine which parties would be tested and what method would be appropriate.

6. What other factors (internal or external) affect the transfer price? This requires a description that is complete and accurate in all material respects of the assumptions, strategies, and policies, if any, that influenced the determination of the transfer prices or the allocations of profits or losses or contributions to costs, as the case may be, for the transaction. This includes all the factors that materially affect the determination of the transfer prices, such as market penetration strategies or any economic assumptions that were relied on to determine the transfer prices. This requirement acts as a kind of catch-all to capture company, market, industry and general economic conditions that may influence transfer prices.

Merv Edwards ([email protected]) and Dean Morris ([email protected]) are principals with Ceteris Canada (www.ceterisgroup.com), an independent consulting business in Toronto that provides transfer pricing and tax valuation solutions. They can be reached by phone at (416) 850-1751.

Originally published in Canadian Treasurer.