Canada: Transfer Pricing Penalties

Many firms and practitioners creating transfer-pricing documentation often attempt, as their primary goal, to avoid costly transfer pricing penalties. Subsection 247(3) of the Canadian Income Tax Act (the "Act") discusses the application of such a penalty. The penalty is 10% of the net adjustment of the transfer price for which the taxpayer did not make a reasonable effort to determine and use arm's length prices [e.g. Insufficient, or lack of, contemporaneous documentation was prepared].

The problem with determining a strategy to avoid penalties is to determine what "reasonable efforts" means. The difficulty with determining reasonable efforts is the fact that it is very subjective and is not defined anywhere in Section 247 of the Act.

What should a taxpayer do with respect to transfer pricing documentation? It is my view that two things must occur, both of which are interrelated. First, the taxpayer must ensure that those creating this documentation are skilled in covering off on all of the transfer pricing issues, such that the auditor cannot logically conclude that reasonable efforts were not met.

Secondly, the transfer pricing documentation must properly address the economic substance of each transaction, which may produce results that reduces the risk of a full-blown transfer-pricing audit occurring in the first place. While some issues will exist that will naturally increase the likelihood of audits, other factors that are well within the control of multinationals must be properly handled. Failure to handle these issues in a correct manner will increase the probability of an audit.

Common Audit Triggers

Here are some common triggers that cause a CRA audit. Good documentation that sets the intercompany price can mitigate the effect of these audit triggers.

Persistent losses experienced by a related party are often a trigger for a CRA audit. While it is entirely possible that a related party can experience reoccurring losses or increased volatility in profit levels, the fact that transfer pricing can result in this outcome occurring, raises the suspicions of tax authorities. If it is determined that a related party should earn negative profits (i.e. for instance if it is a significant risk taker that is experiencing a downturn in the economy), those creating the transfer pricing documentation must sufficiently articulate this in order to show reasonable efforts, and to mitigate the risks of a full-blown audit.

As a rule, profits attributable to a tested party should not be below industry norms. Depending on the characterisation of the tested party, a risk taking entity could incur negative and reoccurring losses, though this should be reversed in better economic times. If the tested party is routine in nature, and assumes little risk, its profitability should be relatively stable and positive. If the returns attributable to a tested party are outside the realm of economic reasoning, and below industry norms, this may increase the suspicion of tax authorities, that may raise a full-blown transfer-pricing audit.

Royalty Payments

Royalty payments are paid when one party uses the trade mark, trade name or other intangible assets of another party. Usually, a related party would be willing to pay a royalty if access to such intangible assets would result in it earning profits that are in excess of what it would have earned had it not had access to such technologies. Utilizing a related party's intangible assets should result in the tested party being better off (even after the royalty payment is made).

However, all to often, we see royalties being used to "strip" profits from a related party. This is contrary to what economic theory suggests should happen. In such circumstances, aggressive royalty payments often increase the suspicions of tax authorities. Properly structuring a royalty based on sound economic principles may be required.

Management Fees

Related parties often pay a related parent company fees for the provision of services. Services that are considered ancillary in nature, but nevertheless are economically valuable, should be allocated at cost. Valued-added services, such as marketing, must be allocated with usually a mark-up. Performing an economic comparable study that compensates them for the provision of services appropriately is a key to reducing the chances of an audit.

Guarantee Fees

As international finance becomes more globalized and competitive, multinational companies, particularly those offering financial services, must ensure that the cost of borrowing money is as competitive as possible to reduce borrowing costs. This often requires that a financially superior foreign parent guarantee the loans of a weaker subsidiary, thereby ensuring the subsidiary access to lower borrowing rates and higher profits. Transfer pricing legislation requires the borrower to pay the guarantor an arm's length fee for providing such a service. Failure to adequately address this issue can result in an auditor undertaking a full-blown audit.

Intangibles Transfers

Firms have an incentive to structure their internal affairs in such a way that profits are migrated to tax jurisdictions imposing lower tax rates. This often involves the transfer of valuable intangible assets to low tax jurisdictions. Tax authorities around the world have begun to target these structures and, as a result, multinational companies need to ensure that documentation is sufficient to support the migration of such intangible assets and to ensure that they meet the arm's length standard. Failure to sufficiently document these transactions based on economic considerations, will increase the risk of an audit.

CRA auditors are gaining greater experience and the taxpayer must ensure that its analysis is sufficiently strong that a CRA auditor cannot challenge it. There are many issues in a transfer pricing study that should be dealt with effectively to avoid a transfer pricing audit. It is important to adequately compensate a related party so that it earns the profits it deserves, and that such profit falls within industry norms. Also, royalties or management fees that seem too aggressive, and that strip too much profit out of a subsidiary, will often be a red flag to auditors. Implementing transfer pricing strategies that are economically sound is the best way to reduce the chance of a transfer-pricing audit. Dealing effectively with tax authorities is only possible if experienced and knowledgeable transfer pricing advisors are consulted.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.