Business Adviser

Do you have a tax time bomb hiding in your inter-company dealings?

By Rob Davis
Partner, Transfer Pricing Tax, KPMG Enterprise, Toronto

If you’re expanding your business by setting up related companies in the US or other countries, you probably have transactions going on between your Canadian company and your related companies that cross international borders. Did you know that these transactions can create a ticking tax time bomb that may go off unexpectedly unless you defuse it by taking action ahead of time?

Like many entrepreneurs, you may think of your group of companies as one big happy family, but once your business crosses borders, tax laws usually require your companies to charge arm’s length, (i.e., market value) prices when they’re doing business with each other. Your business could face costly tax assessments and penalties if tax authorities find that you haven’t complied with these laws.

These “transfer pricing” laws are designed to ensure that each jurisdiction gets its fair share of the tax pie. Essentially, they’re intended to prevent a corporate group from moving its income from one jurisdiction to another by having a company in one jurisdiction pay prices for goods or services to a related company in another jurisdiction that are higher than a company dealing at arm’s length would be willing to pay. From the taxpayer’s point of view, there’s an obvious bias towards shifting income to a lower tax jurisdiction.

Of course, tax authorities pay close attention to large multinational companies’ transfer prices, but they also scrutinize small and medium sized businesses’ transactions with their related companies. We’ve seen the Canada Revenue Agency (CRA) do transfer pricing audits on companies with less than $10 million in revenue. For example, in one recent court case, the amount of tax in dispute was about $100,000. In this case, the CRA challenged a Canadian blueberry farming company’s transfer prices on goods sold to a related US company.

So what do you have to do? Under Canada’s transfer pricing law, if your Canadian company has transactions with related non-Canadian resident companies that total at least $1 million per year, you have to file an annual form disclosing these transactions.

But even if your company’s total transactions are less than $1 million, you still need to be prepared to prove to the CRA that your intercompany transactions use arm’s length prices – not just for goods but also for services like management and administration fees, loan guarantee fees, interest charges on loans, licensing fees and royalties.

Determining arm’s length prices for inter-group transactions can be tricky, especially for services and intangible items like licensing fees. There are several methods that the CRA accepts for determining these transfer prices. To meet the tax law’s documentation requirements, you’ll need to evaluate all the available methods and be able to give your reasons for selecting the method you chose.

For example, you should put together documentation that describes the property or services involved in the transactions, the terms and conditions that apply, the participants and their relationship, the functions performed, property used and risks the parties assumed. Keep in mind that these documents must be “contemporaneous” with the transactions – it’s not advisable to wait until a tax audit to start trying to gather this information.

For transactions with non-arm’s length non-residents, the CRA can go back seven years to reassess transfer prices. For example, I know of a small company that sold goods to a related company in the US in what they thought were uncomplicated transactions. But when the CRA audited the company several years later, it disagreed with the transfer price for the goods. The CRA increased the company’s tax but because the transactions occurred years before, the interest on the unpaid tax actually equaled the amount of tax the company owed, effectively doubling the bill they had to pay. To make matters worse, this CRA interest is not tax-deductible.

To make sure this tax time bomb isn’t ticking in your companies, don’t wait until the CRA arrives at your door to document your transfer prices. I’ve seen too many situations in which companies found years later that the background and rationale for their transfer prices were long forgotten and transaction records were impossible to find, making it difficult to defend the company’s transfer prices against a CRA challenge.

Rob Davis is a partner in transfer pricing tax with KPMG Enterprise in Toronto