Business Adviser

Setting up operations abroad?
Welcome to the wonderful world of transfer pricing

By Joe Devitt
Partner, KPMG Enterprise/Waterloo

Finally - your hard work has paid off. You’ve spent several years establishing your brand in the Canadian market and enjoy a healthy market share. And now all of your research indicates there will be significant demand for your product in the US. After careful consideration, you have set up a US subsidiary to sell your product in the US, and you are ready to send your first shipment. The only thing left is to determine the price at which you will transfer the product to the US related party. As the business owner contemplating this, several questions enter your mind…

“Everything is eliminated on consolidation – does it really matter what price I use?”

“This is my company – surely I can establish pricing as I see fit?”

“Can’t I price my product to take advantage of the tax rate differential between Canada and the US?”

Welcome to the wonderful world of transfer pricing.

If there is any cross-border tax issue that has the potential to cause significant financial uncertainty within a company, it’s transfer pricing. Transfer pricing is simply the price charged for transactions between related parties. Pricing between related parties has historically been a contentious issue with tax authorities around the world, but there has never been as much mainstream focus on the issue as there is today as those tax authorities attempt to rein in badly-needed tax dollars to deal with budget shortfalls. The US government in particular has placed a bull’s-eye squarely on the topic of transfer pricing, as demonstrated by hearings held by the House Ways and Means Committee to address concerns that US taxpayers may be inappropriately shifting income outside of the US through the manipulation of transfer pricing.

Similar to other OECD-member countries, Canada has a specific section of its tax law addressing transfer pricing. These laws also contain potentially significant penalties for non-compliance. In a nutshell, pricing between related parties who are resident in different countries is required to reflect “the arm’s length principle”, which refers to the price at which two arm’s length parties would have transacted under similar circumstances. While this definition appears straightforward, the decisions from various tax courts worldwide, and the statistics published by the Canada Revenue Agency (CRA), tell a much different story. Transfer pricing is a very complex area, and requires a combination of tax law, economics, accounting, and as one judge put it in a recent ruling, “a good dose of common sense”¹.

Thankfully, even with all of this scrutiny by the tax authorities, a taxpayer can at least protect itself from transfer pricing penalties simply by having the required transfer pricing documentation in place. In this regard, the CRA has published guidelines to assist taxpayers in understanding what specific documentation must be prepared. Although the requirements may appear onerous, the up-front work required is certainly worth the effort. In addition to serving as penalty protection, having the appropriate transfer pricing documentation in place is the first step in preparing a line of defense for when (not if) the CRA comes calling in the course of a transfer pricing audit. When you consider the number of taxation years available for CRA to review, the old adage “an ounce of prevention is worth a pound of cure” is well-illustrated. For example, if the CRA were to begin an audit of a taxpayer today, it could examine transfer pricing as far back as 2003. Given the additional tax, interest and penalties that can accrue, taxpayers should not underestimate the financial consequences of having insufficient support for their transfer pricing.

So, as you prepare that first intercompany pricing invoice, ask yourself whether you are prepared to defend your transfer pricing, both in Canada and abroad, and whether you have the transfer pricing documentation in place to give you the comfort you need so you can focus on what really matters – growing your business.

¹See General Electric Capital Canada Inc. v. The Queen, Can. Tax Ct., 2006-1385(IT)G, 12/4/09

Business Adviser is published by KPMG Enterprise™ specifically for owners and executives of private companies. KPMG Enterprise is devoted exclusively to helping business owners and entrepreneurs build thriving enterprises. For further information about how KPMG Enterprise can help private companies, visit www.kpmg.ca/enterprise.