Transfer Pricing: What You Need to know and Do if CRA Assessed You With Improper Transfer Pricing Under Section 247 of the ITA.

Transfer pricing refers to the price Canadian-resident businesses pay when they buy and sell goods or services from a related, foreign party, such as a subsidiary. There are many sound business reasons why businesses may purchase from related parties. Often they can save costs on packaging and shipping. They also know they are dealing with a trusted party.

The Department of Finance, however, worries that businesses can use such transactions to reduce their tax burden by transferring profits to lower-tax jurisdictions or artificially inflating their losses. Consequently, it has enacted strict transfer pricing rules that try to limit how Canadian taxpayers can transact with their foreign partners. Under these rules, the Canada Revenue Agency (“CRA”) can reassess the value of a transaction and the tax payable on it by the Canadian taxpayer. It can also levy penalties. Over the past few years, the CRA has taken an increasingly aggressive stance towards transfer pricing, expanding the scope of its investigations and enforcement.

However, despite the CRA’s dogged pursuit of such transactions, taxpayers can successfully defend their transfer pricing transactions against assessments by the CRA, particularly when they partner with an experienced tax dispute resolution team.  

What are the Transfer Pricing Rules?

The Transfer Pricing Rules are found in section 247 of the Income Tax Act (“ITA”). They stipulate that any transaction, or transfer, undertaken between a Canadian resident taxpayer and a non-resident party with whom the taxpayer does not deal at arm’s length must, nevertheless, be priced at an arm’s length price. In other words, taxpayers must transact with their related foreign parties in the same way that they would with unrelated, arm’s length parties.

If the CRA believes that a transaction does not abide by this “arm’s length principal,” it will adjust the transaction price to the amount that it believes would apply between arm’s length parties and impose tax on the adjustment amount. It can also adjust a transaction where it believes that the transaction was undertaken solely for a tax benefit, one that the parties would not have entered into if they were dealing at arm’s length.

Additionally, under s.247(3), the CRA can impose a penalty of 10% of the adjustment amount where the adjustment amount is more than $5 million or 10% of the taxpayer’s gross revenue for the tax year in which the transaction was undertaken.

Small businesses with modest annual gross revenues are particularly susceptible to this penalty. For example, if CanCo sold a good to its foreign subsidiary for $100,000, but CRA determined that the arm’s length price of the good to be $150,000 CanCo would have to pay tax on the $50,000 adjustment. If CanCo’s gross revenue for the year was less than $500,000, it may also have to pay a $5,000 penalty (i.e. 10% of the adjustment amount), as the adjustment amount ($50,000) would be more than 10% of CanCo’s gross revenue.

How to defend yourself against the Transfer Pricing Rules

Section 247 ultimately comes down to whether the impugned transaction was priced at arm’s length. The ITA, however, does not provide instructions on how to determine the appropriate arm’s length price. This leaves the question of appropriate transfer pricing open to wide interpretation.

The CRA determines the arm’s length price using the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations prepared by the Organization of Economic Co-Operation and Development (“OECD”)[1] These Guidelines are constantly being revised and contain various methods for calculating the arm’s length price, each of which can yield a different price.

Appropriately, Canadian courts have taken a more holistic approach to determining the appropriate arm’s length price. While they have occasionally relied on the OECD Guidelines, they have also stressed that OECD Guidelines—or any other guidelines or approaches—are not legally binding. As the Tax Court noted in McKesson Canada Corp v R , rather than follow any set methodology, “[a] judge is to take into account all transactions, characteristics and circumstances that are relevant (including economically relevant).” [2]

Taxpayers will thus be well positioned to satisfy the courts that their transaction is properly priced if they can provide supporting documents from the time of the transaction outlining the “characteristics and circumstances” surrounding the transaction and the rationale for the transfer price.

Contemporaneous documentation can also help defend against the 10% penalty. The penalty under s.247(3) only applies to the extent that taxpayer did not make “reasonable efforts to determine and use arm’s length transfer prices.” So, if the taxpayer can show that reasonable efforts were made during the time of the transfer to determine and use the arm’s length price, the taxpayer will not be penalized even if the transfer price was not arm’s length. This defence is specifically provided for under s.247(4).

Considering the broad purview endorsed by the courts, relevant documentation can include everything from licenses, purchase and sale agreements, contracts, market reports, economic data, and any other document that provides context to the transaction in question and shows that it is reasonable. For as the Supreme Court of Canada noted, “as long as a transfer price is within what the court determines is a reasonable range, the requirements of [the transfer pricing rules] should be satisfied.”[3] Comfortingly, the CRA has lost most of the major transfer pricing cases to date.

Conclusion

The law surrounding transfer pricing is complex and constantly evolving. If you received a transfer pricing assessment, or if you are considering a transaction that you fear may one day trigger s.247, contact Dean Blachford at Blachford Tax Law to discuss your options. Blachford Tax Law has extensive experience working with taxpayers and their accountants to successfully manage CRA audits and dispute CRA assessments.

Disclaimer

This article is for informational purposes only and does not constitute legal advice. If you wish to discuss your issue with a lawyer, contact us today at (613) 702-0322 or info@blachfordtaxlaw.com

[1] https://www.oecd.org/tax/transfer-pricing/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-20769717.htm

[2] 2013 TCC 404 at para 120.

[3] GlaxoSmithKline Inc v R, 2012 SCC 52 at para 61.