Recently, many of our clients have set up (or are contemplating setting up) operations in the United States to take advantage of favourable export exchange rates. American subsidiaries owned by the Canadian parent company are one way to carry out operations. This approach with readily understood tax filing obligations and reporting forms for both jurisdictions, also brings with it the more complex issue of transfer pricing.
Simply put, “transfer pricing” is the setting of the price for goods and services sold between related entities within an enterprise. For example, if a parent company sells goods to a subsidiary company, the cost of those goods paid by the subsidiary to the parent is the transfer price.
Canada's transfer pricing legislation embodies the arm's length principle. This means that taxpayers who are non-arm's length members of a group and engage in transactions with other members of the same group, must report substantially the same amount of income as they would if they had been dealing with each other at arm's length.
The transfer prices adopted by a group of non-arm’s length members (subsidiaries), directly affects the profits reported by each of the parties in their respective countries. Consider the following scenarios:
- Scenario 1: Canada Co. produces a widget at a cost of $700. Sells to US Co. for $700. In turn, US Co. sells to third parties for $1,000. Profit in Canada Co. is $Nil and in US Co. is $300
- Scenario 2: Canada Co. produces a widget at a cost of $700. Sells to US Co. for $1,000. In turn, US Co. sells to third parties for $1,000. Profit in Canada Co. is $300 and in US Co. is $Nil.
Under the assumption that the tax rate in Canada is 15% and in the US it is 25%, Scenario 2 becomes more attractive due to the 10% tax saving. As such, a corporation could be inclined to manipulate its transfer price so as to achieve a more favourable result.
The arm's length principle, however, treats a group of parties not dealing at arm's length as if they operate as separate entities rather than as inseparable parts of a single unified business. This determination is generally based on a comparison of:
- Prices or margins between non-arm's length parties on cross-border transactions (known as "controlled transactions") and
- Prices or margins on similar transactions between arm's length parties ("uncontrolled transactions").
Instances where the taxpayer is challenged on the application of the arms-length principle are reviewed on a case-by-case basis. Documentation of transfer pricing documentation is typically required by law and non-compliance could lead to penalties.
Recognizing that the burden of proof for transfer pricing procedures is on the taxpayer, it is in a company’s best interests to ensure they have adequate documentation.
