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: