COMMENTARY — Benefitting from transfer pricing

The Canadian government has been tightening up its transfer pricing regime in an effort to bolster the Canadian fiscal position.

The price charged by one affiliate of a multinational to another, across an international border, for goods, services or intangibles, is known as a transfer price. The laws dealing with transfer pricing have become much more onerous of late — or, at least, much more specific in their requirements — and the audit activity in this area has increased dramatically.

This issue is relevant to a growing number of Canadian miners that have come to view their homeland as increasingly hostile to mining operations and have begun to look beyond its borders. Although transfer pricing is not a new issue, the fact that it has captured the attention of governments worldwide means multinationals must pay close attention.

For the past several years, the Department of Finance — the arm of the Canadian government responsible for establishing the laws that govern taxation — has been introducing comprehensive reporting and taxation rules for cross-border trade. At the same time, Revenue Canada — the arm of the Canadian government responsible for administering the taxation laws — has been increasing its scrutiny of such transactions.

Historically, the Canadian transfer pricing requirements were fairly limited; for income tax purposes it was required only that transfer prices represented a “reasonable amount” in the circumstances. There were no specific standards as to the documentation needed to support those prices.

Recently passed legislation significantly alters the Canadian transfer pricing requirements. The new law states that cross-border prices between parties not dealing at arm’s length may not differ from those that would have been agreed to by persons dealing at arm’s length. If a difference exists, Revenue Canada can adjust both the quantum and the nature of the transaction when calculating taxable income. A significant part of the law, which took effect Jan. 1, 1997, is a requirement to keep adequate documentation to support a company’s decisions regarding transfer pricing.

Businesses often intuitively believe they know what the right price should be for their inter-company transactions and set their transfer prices accordingly.

Unfortunately, governments don’t understand businesses well enough to accept business judgement or intuition, and require proof in the form of documentation as to how the prices were set and why they are right.

Failure to produce adequate documentation can result in significant penalties — 10% of the amount of the error, payable even if you are not taxable. If you are taxable, the penalties are in addition to the tax owing and non-deductible interest charges.

These developments mean that businesses operating in Canada need to pay closer attention to cross-border commerce generally, and transfer pricing specifically, to ensure they are not paying too much tax or being exposed to an unnecessary risk of penalties.

Governments view transfer pricing as a source of additional tax revenue or, at the very least, a mechanism to protect their existing tax base. As such, cross-border trade tops the agenda of virtually every government in the world. But are the new transfer pricing rules really only a means to increase taxation revenues for governments? Maybe not. The government’s requirement to carefully establish and document transfer prices can provide surprising benefits for businesses. Careful selection of transfer prices should be an integral part of the overall global tax planning by any multinational. Transfer pricing can help a business maximize its profits in the lowest-taxed jurisdiction in which it operates. It is often difficult for the revenue authorities of any government to argue with tax planning properly supported by effective legal arrangements and economic analysis.

Although compliance with the government’s new requirements may initiate a transfer pricing review, the outcome may very well reduce a company’s overall global effective tax rate; not a bad byproduct of the government’s mining-related efforts.

— The author is a partner with the Calgary office of KPMG and part of the firm’s global economic consulting practice.