Canada: IFRS: Transitional Impact On Transfer Pricing Analysis

Companies may interpret and apply IFRS differently, which may compromise comparability of financial statements

Transfer pricing involves the determination of an arm's length price that one member of a multinational firm should charge another for the sale of goods, services and intangibles across provincial/state and international borders. The determination of an arm's length price for a transaction between related parties is a complex, subjective and lengthy exercise. The planned switch to International Financial Reporting Standards ("IFRS'') in many countries will considerably complicate matters. IFRS is a set of accounting standards developed by the International Accounting Standards Board. Currently, over 100 countries allow or require publicly traded companies to prepare their financial statements in accordance with IFRS. The member countries of the European Union have required the use of IFRS since 2005 while other countries like Canada have only recently made the transition. Conversely, IFRS is not expected to be adopted until 2015 or 2016 at the earliest in the US. Even then, it is likely that there will be different rates of adoption and different or staggered transition periods. This article examines the impact of IFRS on transfer pricing in relation to Canadian and US companies with intercompany cross border transactions.

l. Comparables and transfer pricing methodologies

The Organisation for Economic Co-operation and Development ("OECD") outlines a number of methodologies that can be used to determine the arm's length returns attributable to the tested party within a transfer pricing setting. In general, these methodologies require locating comparable arm's length transactions to test the prices charged to one or more related parties by the tested party. The companies that undertake these arm's length transactions must perform and assume similar functions, assets and risks as the tested party. Otherwise, the results of the transfer pricing analysis will not be reliable as companies with materially different functions, assets and risks will likely charge different prices for a same or similar transaction. Thus, in any transfer pricing exercise, rigorous techniques must be applied to find comparable companies in order to properly and reliably attribute profits to the tested party.

While each search for comparable companies will be different, a typical search begins by locating comparable companies that fall within one or more Standard Industrial Codes (SIC). After this preliminary step, qualitative and quantitative screens are used to arrive at a set of ""comparables'' that mimic the tested party both functionally and in terms of risks assumed and assets pledged. Given the subjective nature of values placed on these functions, assets and risks, the search for comparable companies is a subjective exercise. Typically, once the comparable companies have been identified, the most appropriate transfer pricing methodology to determine arm's length price can then be ascertained.

All transfer pricing methodologies require detailed financial information on the comparable companies. Therefore, the availability and quality of such information will also dictate the final methodology to be selected.

Other than the Comparable Uncontrolled Price (CUP) method, all transfer pricing methods rely on information or data that will be impacted by the introduction of IFRS. Given that the CUP relies on a market determined "price'' of a particular transaction, the manner in which financial statements are reported will not have a bearing on the application of this methodology and the determination of an arm's length price. All the remaining methodologies, such as the total cost plus or resale minus methods, rely on financial metrics or information that are directly af fected by the accounting method used. Given that CUP is the least used methodology when documenting intercompany transactions, the implementation of IFRS will have considerable ramifications on transfer pricing exercises. A company may be precluded from adopting certain transfer pricing methodologies if accounting differences between the tested party and comparable companies result in material differences in the relevant profit level metric.

ll. Transition period

As mentioned, determining the transfer price associated with a given intercompany transaction requires the derivation of a set of comparable companies that resemble the tested party. While qualitative and quantitative screens can be used to achieve this, the introduction of IFRS adds another level of complexity to the analysis.

Due to different rates of adoption, it is inevitable that some US companies will be IFRS compliant while others may not be. Within a transfer pricing analysis, this may result in distortions given that the comparables selected may include a mixture of companies that report their profits under a different accounting regime relative to the tested party. This will likely reduce the number of comparable companies available and make the determination of an arm's length price more difficult.

Until IFRS is fully implemented, a transfer pricing analyst will need to determine whether the comparables and tested party have prepared their financial statements in a similar fashion. If it the respective financial statements were prepared under different accounting regimes, the analyst must then determine if the accounting differences are material, and whether adjustments to the financial statements can be made to improve comparability. This will not be an easy task. In fact, given the complexity of accounting standards and preparing financial statements, unless the relevant companies disclose the differences in their financial statements from using IFRS versus the old or existing accounting regime, it may be impossible for the transfer pricing analyst to make the necessary adjustments or even evaluate the impact of differing accounting standards on the financial statements of the comparable companies.

The same challenge exists for Canadian companies that use US companies as comparables and vice versa. Even though the prior set of Canadian Generally Accepted Accounting Principles (""GAAP'') was never identical to US GAAP, Canadian companies that want to use US companies as comparables, and vice versa, must now undertake a new exercise to the determine the differences between IFRS and US GAAP and make the necessary adjustments if possible.

Furthermore, the transition to IFRS will also be problematic for companies that use internal benchmarks instead of arms length companies as comparables. A credible and defensible intercompany transfer price for a particular product can sometimes be established by reference to the sale price of a similar but not identical product that is sold to arms length parties. For instance, assume that a company manufactures and sells truck widgets to its foreign subsidiary and also sells car widgets to arms length companies. Also assume that the company bases its intercompany transfer price on the cost plus method (gross profit over cost of goods sold) on sales to arms length parties. If the adoption of IFRS alters the manner in which the reference gross profit markup is calculated, the company will have to revisit its transfer pricing policy.

A change of accounting regimes also complicates matters for companies, both related or unrelated, with cost contribution agreements (""CCA''). A CCA governs the manner in which a group of companies share and allocate costs related to the development of intangible property in return for an interest in the resulting intangible property. The costs are usually allocated in reference to a financial metric like expected benefit of the intangible property. Depending on the metric used, the switch to IFRS may alter the manner in which the reference metric is calculated or determined. In Canada, there are several differences between Canadian GAAP and IFRS with respect to revenue and expense recognition. For example, under certain circumstances, IFRS may require a company to recognise more compensation expense from stock based compensation than under Canadian GAAP thereby lowering the company's accounting profit under IFRS even without any changes to its underlying operations and economics. Consequently, if this company is party to a CCA that uses an expected profitability metric, the cost allocated to the company under the CCA will change. Depending on the circumstances, this may work to the detriment of a corporate group if more costs are re-allocated to related companies in lower tax jurisdictions simply due to a change in accounting methodology.

Canadian companies that just adopted IFRS should review and adjust existing transfer pricing policies as the adoption of IFRS would have likely changed the underlying financial metrics used to create these policies. With respect to US companies, they should be proactive and take into account IFRS when setting transfer pricing policies that straddle the period before and after the adoption of IFRS.

lll. Concluding remarks

In general, the adoption of IFRS and convergence of accounting standards is a positive development that will improve cross border comparability of financial statements, enhance transparency, and reduce costs associated with the preparation of financial statements for companies with international operations.

These same benefits apply equally in the context of transfer pricing. As IFRS is fully implemented, distortions in financial and pricing information due to accounting differences of comparable companies located in IFRS compliant countries will be greatly attenuated.

In addition, the cost of preparing contemporaneous documents and conducting transfer pricing analysis will be reduced if the foreign subsidiaries are also using IFRS as their primary reporting standard. Regardless, even after the transition, IFRS may still be problematic. Unlike Canadian and US GAAP, IFRS eschews detailed and specific rules. Instead, IFRS is based on broad principles that provide general guidance for the preparation of financial statements, rather than setting rules for industry and transaction specific reporting. Hence, the possibility remains that companies may interpret and apply IFRS differently in similar circumstances, thereby compromising the comparability of financial statements or metrics.

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