The ongoing US deficit crisis has resulted in President Barack Obama proposing to increase taxes. This initiative will only put more pressure on the US Internal Revenue Service (IRS) to increase its review of transfer pricing between multinational groups of companies.
According to the tax law in Canada, the United States and other developed countries, the proper transfer price is one that two parties dealing at arm’s length would agree to for a certain transaction. Consequently, the resulting price is called an “arm’s length price,” and the principle used to determine such a price is an “arm’s length principle.” This arm’s length principle or rationale is a cornerstone of transfer pricing methodologies used by tax administrators in the majority of countries worldwide.
Simply put, the objective is to guarantee that related companies sell their goods, services, tangible and intangible assets to one another at market prices for tax purposes.
Disputes over transfer pricing tend to arise from transactions between related parties (i.e. normal parent/subsidiary relationships) located in both the US and Canada. Typically, the corporate group has the rationale with respect to the jurisdiction in which it would like its profits taxed, yet this can lead to inappropriate inter-company charges that facilitate an income shift to the lower tax rate country.
In recent years, the Canada Revenue Agency (CRA) and the IRS increased their emphases on transfer pricing inspections. In addition, the new legislation includes penalties for failure to produce documentary evidence verifying the proper transfer price. Consequently, even smaller companies have become more concerned about the potential of a transfer-pricing audit.
The best solution to mitigate tax audit issues is to complete a detailed transfer pricing study on a current basis to support the inter-company charges and cost of goods sold. You should be aware also that penalties and interest charged by the revenue authorities on both sides of the border can be substantial and non-deductible for tax purposes.
Despite many government pronouncements to the contrary, the determination of proper transfer prices remains subjective. Consequently, careful analysis is needed to judge the impact of several key factors such as the company’s activities, risks, tangible and intangible assets employed, characterization of the entities and comparability of arm’s length with non-arm’s length transactions.
The Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations provide guidance on the application of the “arm’s length principle” for the valuation — for tax purposes — of cross-border transactions between associated enterprises. For taxpayers, it is critical to limit the risks of economic double taxation that may result from a dispute between two countries regarding the arm’s length remuneration for their cross-border transactions.