International business expansion is a complex process that must be done strategically in order to minimize risk, limit potential tax liabilities and maximize profits. Our Doing Business Globally series is designed to give Canadian companies the advice they need to reduce risk, limit exposure and successfully expand into global markets. Part 3 of our 4 part series provides strategic advice on creating an effective transfer pricing strategy.
As more businesses look to expand their market share beyond Canada's borders, issues such as business structure, international taxes and repatriation of profits quickly become top of mind. Yet one relevant area that many business owners overlook is transfer pricing.
While many think that transfer pricing is mainly the concern of large multinational corporations, any business operating in another jurisdiction can run afoul of tax laws governing transfer pricing without proper care and planning. Tax laws relating to transfer pricing, which are designed to ensure that related companies in separate countries transfer goods, services, financing and/or intangibles between them at an arm's length price, can come into play for even small and mid-sized companies making their first forays outside of Canada.
Developing a transfer pricing strategy
Any intercompany transactions that cross country borders make transfer pricing laws relevant. If your business is setting up any kind of foreign affiliate, or is already doing business abroad, transfer pricing must be on your corporate radar.
When developing your transfer pricing strategy, there are three key areas to consider:
Supporting the strategy
Regardless of the level of risk that you choose to take on when developing your transfer pricing strategy, it is important to back up the strategy with proper analysis and documentation. Should a company come under scrutiny for inter-affiliate transactions, either by the CRA or the tax authorities in the foreign jurisdiction, this documentation will be critical to support the arm's length prices used for your goods, services and/or intangibles.
In addition, if your cross-border intercompany transactions exceed $1M, you will also have to file Form T106 – Information Return of Non-Arm's Length Transactions with Non-Residents, which details all corporate transactions with related parties outside of Canada. The CRA gives careful scrutiny to the information provided in this form, especially in situations where management fees, royalties or interest are paid between related companies.
The cost of non-compliance
Many governments are taking an increasingly aggressive position against possible non-arm's length transfer pricing in an attempt to reduce losses to tax revenues. Countries such as Canada, the U.S., the UK, Australia and Germany are known to aggressively audit, penalize and litigate transfer pricing cases. Around the globe there is increasing pressures on transfer pricing as a result of the OECD's Base Erosion and Profit Shifting (BEPS) action items, resulting on more emphasis on factual and economic substance and the transfer pricing documentation required to evidence such substance.
Within Canada, if the CRA wants to audit your company's transfer pricing, then your company would receive a letter requesting that you provide the company's contemporaneous documentation. You would get three months from the date of the letter to provide the economic analysis and transfer pricing documentation to support your intercompany pricing. An auditor would then confirm all details.
Should the auditor's findings disagree with the documentation, the CRA would then reassess the business's Canadian income upward, resulting in higher taxes and more interest. Additionally, if your business has not completed appropriate contemporaneous documentation, you would also pay a penalty of 10% on the full amount of the adjustment to income. This can have a substantial financial impact. For example, for a Canadian company paying a 26% effective tax rate, the penalty would take the tax rate on the adjusted income to 36%. Domestically, the CRA can reassess and penalize transfer pricing adjustments within seven years from the date of the original Notice of Assessment.
Appealing a reassessment
A major concern upon reassessment is double taxation. In essence, when the CRA adjusts the company's Canadian income, the business has to pay tax on income that has already been taxed in the foreign jurisdiction. In this situation, you can go to Competent Authority (under Canada's tax treaties with other countries) and request that they negotiate an acceptable conclusion. In the easiest case scenario, the foreign country would grant a deduction for the same amount that the income was increased in Canada. It is important to note that Competent Authority is often a difficult process, but the use of mandatory binding arbitration to solve the fight over tax base between counties is making the process easier on taxpayers. Recent cases that BDO has been involved with, involving Canada and the U.S., were resolved expeditiously immediately before the deadline to advance the case to binding arbitration (i.e., two years after the initiation of competent authority proceedings).
If the foreign affiliate is located in a country with which Canada has a tax treaty, this is the method by which most of these issues are resolved. If, however, no tax treaty exists or the authorities cannot agree on a ruling, appeals and then court may be the only viable route.
An appeal to the CRA could result in the case being overturned, a modification of the reassessed amount, or verification of the auditor's findings. Should you still disagree with the ruling, you would have the option of taking the case to the Tax Court of Canada and beyond.
Top recommendations for small/medium business owners
If your company is considering a foreign expansion, transfer pricing might not be at the top of your list of priorities, but it absolutely should be on your radar. If you are planning an international expansion or your company has already started foreign operations, here are three critical areas to help mitigate your risk:
For specifically tailored advice on developing a transfer pricing strategy, or for assistance with transfer pricing analysis and documentation, please contact our BDO Transfer Pricing Practice Leader or your BDO Advisor.
The information in this publication is current as of June 10, 2017.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.