Proactive planning and preventative procedures can save big headaches and expenses

Wthout proper policies and documentation in place, transfer pricing audits can result in long and costly corporate headaches. Even if the 10% pricing adjustment penalty (plus interest) is not applied, a transfer pricing audit can be costly in terms of Part XIII tax, remedial documentation costs, management time and professional time.

Transfer pricing continues to be an area of great concern to the Canada Revenue Agency (CRA). In fact, to ensure that Canada receives its fair share of tax on any international business conducted by related parties, the CRA employs approximately 500 designated international tax auditors. As a result, companies of virtually any size can find their international related party transactions under review.

Corporations (as well as other legal entities) that have non-arm's length transactions with non-residents are required to file a Form T106: Information Return of Non-Arm's Length Transactions with Non- Residents.

Question six of the Form T106 asks if the taxpayer has contemporaneous documentation on hand pursuant to subsection 247(4) of the Income Tax Act. A "no" answer would likely increase the chances of a transfer pricing audit.

Routine CRA audits can also lead to transfer pricing audits, particularly if contemporaneous transfer pricing documentation cannot be provided when requested. Although a company has 90 days from the date of the request to provide the documentation, it may not be prudent to wait until formally requested. From the auditor's perspective, the appearance may not be good when companies have to scramble together transfer pricing documentation which (technically) should already be in place.

Aside from the normal trade in goods, routine audits commonly highlight the following types of non-arm's length international corporate transactions for further transfer pricing scrutiny:

  • Inter-company management fees
  • Inter-company service fees
  • Shared costs
  • International business restructuring
  • Intangible transfers to offshore jurisdictions
  • Intangible royalties
  • Guarantee fees on intercompany financing

Auditors also typically request the intercompany agreements and transfer pricing polices underpinning the cross border transactions. The auditors check to ensure that the company is acting in accordance with the provisions of the agreements and policies.

Other transfer pricing red flags which may be identified when reviewing corporate information and transfer pricing documentation include:

  • Mischaracterized transactions or company roles
  • Atypical comparatives/ratios
  • Large year-end transfer pricing journal entries which are not well documented
  • Unreasonable/unexplainable operating results, such as chronic losses and/or low profitability
  • Cross-border operations restructuring shifting profits to other jurisdictions
  • Payments of withholding taxes which do not reconcile with T106 disclosures or other transfer pricing documentation
  • Transactions with low-tax jurisdictions

The best way for a company to protect itself from the potential headaches of an extended transfer pricing audit is to ensure, on an annual basis, that: (1) proper transfer pricing policies and agreements are in place; (2) the company operates in accordance with said policies and agreements; and, (3) the company diligently assembles (in advance) the annual contemporaneous documentation to prove same.

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