Intercompany Transfer Pricing

Many governments have recently become extremely concerned that multinational companies may be artificially shifting profits from one country to another by manipulating intercompany pricing.

This has been a difficult issue for companies to deal with, historically, since few guidelines existed concerning intercompany pricing methods. Where guidelines did exist, they were often different from country to country.

Countries around the world, including Canada, are now slowly harmonizing their approach to transfer pricing. Federal Finance Minister Paul Martin issued draft legislation on transfer-pricing measures, in September, 1997 which conforms to guidelines issued in 1995 by the Organization for Economic Co-operation and Development. Many of the OECD member countries, including the United States, have adopted these rules.

Highlights of the Legislation
Highlights of the legislation, which are effective for taxation years beginning in 1998, include:

• Taxpayers who participate in crossborder transactions with related parties must conduct such transactions on terms and conditions that would be used for arm's-length transactions;
• Taxpayers who participate in crossborder transactions with related parties must document their transfer-pricing transactions to ensure the terms and conditions satisfy the arm's-length principle; and
• Taxpayers may be subject to penalties where they fail to make reasonable efforts to determine and use arm's-length transfer prices for crossborder transactions with related parties.

Application Methods
The legislation endorses several methods of applying the arm's-length principle. Two types of these methods are those based on transactions and those based on profits.

Acceptable transactional based methods are:

• Comparable Uncontrolled Price, which uses prices in comparable transactions with, or between, independent third parties;
• Cost Plus, which adds a reasonable markup to the cost of production of goods or services; and
• Resale Price, where the eventual resale price of the goods or services is reduced by a reasonable markup.
• Where these methods cannot be used, Revenue Canada will accept one of the following profit-based methods:
• Profit Split, which determines the division of profits that independent entities would have expected to realize in the transaction; or
• Transactional Net Margin, which uses the net-profit margin realized from a comparable uncontrolled transaction.
• Although each of the endorsed methods is acceptable, taxpayers must choose the one that most reflects the arm's-length standard in a particular type of transaction.

Applicable Penalties
The legislation will impose substantial penalties - 10 per cent of any pricing adjustment made by Revenue Canada upon audit - for failure to comply with transfer-pricing rules.

However, the penalty will not be imposed if the taxpayer has made reasonable efforts to determine arm's-length prices.

Reasonable efforts will be deemed used if:

• An acceptable transfer-pricing method was used; and
• Adequate documentation of the transaction, as set forth below, was made within 60 days of the end of the year in which the transaction took place.

No Penalty

• A minimum threshold exists for imposing the penalty.
• Penalties will not be imposed if Revenue Canada's transfer-pricing adjustment is less than both 10 per cent of the taxpayer's gross revenue for the year and $5 million.
• For example, if xyz Company had gross annual sales of $4.9 million and Revenue Canada made adjustments of $600,000, the penalty imposed would be 10 per cent of $600,000,or $60,000.

However, if Revenue Canada's adjustments totalled less than $490,000, no penalty would be imposed since the 2 minimum threshold amounts were not met.

Each Country Differs
It's important to remember each country has its own penalty regime. Therefore, although a taxpayer can take measures to avoid penalties in one country, if not careful, that taxpayer may be subject to penalties in another country.

As discussed, the legislation requires taxpayers to maintain a high standard of documentation of their transfer price.

Necessary Documentation
Documentation must include a complete and accurate description of:

• The property or services to which the transfer price relates;
• The terms and conditions of the transaction and their relationship, if any, to the terms and conditions of other transactions between the participants;
• The identity of the participants, and their relationship at the time of the transaction.
• The functions performed, the property used or contributed, and the risks assumed by the participants;
• The data and methods considered and the analysis performed to determine the transfer prices; and
• The assumptions, strategies and policies, if any, which influenced the determination of the transfer prices.

Review Your Strategy
In light of the increased attention and the resources governments, including Canada, are investing in intercompany-pricing audits, any companies involved in transactions with foreign affiliates should review their strategy and documentation to ensure governmental guidelines are being followed in all the countries with foreign affiliates.

The foregoing comments are of a general nature, and are not intended nor should they be used as a substitute for legal advice or opinions which can be rendered only when related to specific fact situations.

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