The Canada Revenue Agency (“CRA”) regularly reviews transactions between related corporations when one is Canadian resident and one is not. One of the main reasons for this is “transfer pricing”. As indicated by the CRA, “[t]ransfer prices are the prices at which services, tangible property, and intangible property are traded across international borders between related parties.” When a Canadian resident corporation trades property or services to a non-resident related corporation the transfer price is not always the fair-market value for that particular item. Transfer pricing becomes an issue in such a circumstance. For tax purposes, the price that should have been paid on the open market (fair-market value) will be deemed by CRA to be the transfer price. This ensures that the transaction is taxed accordingly and doesn’t become a tax problem.
Transfer pricing strategies can sometimes be an effective tax avoidance mechanism, hence the rules controlling it. Consider the following basic example of a Canadian resident corporation (“Cancorp”) with a subsidiary in Mexico. The Canadian corporation manufactures a product that it sells to its Mexican subsidiary (“Mexcorp”), which sells the product in the Mexican retail market. Cancorp can set the price to be paid for the product by Mexcorp, a non-arm’s length party. Without transfer pricing standards, Cancorp could sell to Mexcorp at an artificially low price; therefore the profit margin would be taxed in the presumably lower tax jurisdiction of Mexico. In the alternative, if the respective tax rates were lower in Canada, Cancorp could charge an artificially high amount for the product sale to Mexcorp, again ensuring a portion of the profit is taxed in the lower tax jurisdiction.
Currently, transfer pricing laws in Canada permit CRA to undertake price adjustments to reflect fair-market value. Pursuant to subsection 247(2) of the Income Tax Act, the transfer price must be a price that would have been reasonable in the circumstances if the non-resident person and the taxpayer had been dealing at arm’s length. Referring to the example above, Cancorp would be required to sell the product to Mexcorp at a fair-market value, in other words at a price Cancorp as the manufacturer would sell to a non-related or arm’s length retail corporation.
The penalties for trading property or services between a Canadian resident corporation and related non-resident corporation at a transfer price CRA considers inadequate can be substantial depending on the size of the transaction; in some cases 10 percent of the net adjusted amount (the difference between the impugned transfer price and the fair-market value).
To contest CRA’s transfer pricing adjustment you must demonstrate reasonable efforts to determine a fair market value prior to the transaction. Furthermore, if the taxpayer has made reasonable efforts to determine the correct transfer price a reduction in tax penalties is possible. Reasonable efforts can be established by contemporaneous documentation that proves that the taxpayer took steps to determine the fair-market value of the property or services traded at the time the transaction is entered into. A few examples of contemporaneous documentation include records establishing the following:
- The property or services to which the transaction relates
- The terms and conditions of the transaction
- The identity of the participants and their relationship to each other
- The data and methods considered
- Analysis performed to determine the transfer price
- Assumptions, strategies and policies that went into the transfer price
- Any other document relevant to the determination of the transfer price.
Also, as was recently affirmed by the Supreme Court of Canada (“SCC”) in Canada v. GlaxoSmithKline Inc., 2012 SCC 52, determining the price that would have been reasonable if the buyer and seller were dealing at arm’s length requires a “consideration of all the circumstances of the Canadian taxpayer relevant to the price paid to the non-resident”.
At issue in Glaxo was the correct amount to be paid for a pharmaceutical ingredient bought by GlaxoSmithKline’s Canadian operation and sold by a related or non-arm’s length foreign supplier. The Minister of National Revenue (the “Minister”) reassessed GlaxoSmithKline on the basis that the transfer price for the pharmaceutical ingredient was inflated. In fact, the price paid by GlaxoSmithKline was between five and seven times higher than the price paid by other corporations for the same ingredient. The reassessment by the Minister increased GlaxoSmithKline’s income by approximately $50 million for the 1990 through 1993 taxation years.
The Minister argued that since similar businesses had paid a much lower price for the same ingredient that was the price that should have been paid by GlaxoSmithKline. However, what the Minister failed to take into account, according to the SCC, was a related agreement that also transferred certain rights and benefits that accompanied the purchase of the ingredient. Essentially, GlaxoSmithKline was purchasing more than just the pharmaceutical ingredient and the price should reflect that. Ultimately, the SCC ruled that the measure of the correct transfer price has to include all the circumstances surrounding the transaction.
As you can see, transfer pricing is a complex area of tax law. If you trade property and services between your Canadian resident corporation and a related non-resident corporation you should ensure that the proper pricing methods are in place. It is well within CRA’s power to adjust a taxpayer’s pricing in order to reflect what two non-related corporations would have traded the property or services for on the open market. Remember, it is up to the taxpayer to establish proof of reasonable efforts to ensure the correct transfer price.
If you are worried that CRA may commence a transfer pricing adjustment, or if they already have, we can help. If you require advice on the steps to take to prove reasonable efforts to ensure the correct transfer price, we can help. Contact us to set up an initial consultation with our experienced Canadian tax lawyers.