Canadian tax law is premised on the fundamental principle that tax consequences of all transactions, including transfers of goods or provision of services between related parties, should be determined in accordance with the “arm’s length” principle. Where the parties to a transaction or series of transactions do not deal with each other on arm’s length terms or prices, the tax consequences of that transaction may be adjusted by the Canada Revenue Agency (CRA) in accordance with special provisions of the Income Tax Act (Canada), specifically the transfer pricing rules found in section 247. The CRA has provided guidance with respect to cross-border transactions in its Information Circular IC-87R2, International Transfer Pricing. In general, Canadian transfer pricing principles follow the principles adopted by the Organization of Economic Cooperation and Development (OECD). However there are some particularities to the way that the CRA has been interpreting the Act and the OECD Guidelines. Canada’s tax treaties also play a role in resolving transfer pricing issues in certain circumstances.
Canadian transfer pricing rules are very broad. In essence, they allow for the tax consequences of transaction between non-arm’s length persons (i.e., related parsons, such as members of a corporate group) to be changed from the results (prices, terms, etc.) as agreed to by the parties, to be either adjusted or re-characterized to achieve an outcome more consistent with what ought to have been the price and/or terms if the parties had been completely economically independent. If the application of transfer pricing provisions in the Act results in such an adjustment, a taxpayer may be subject to a transfer pricing penalty, in addition to any tax, interest and administrative penalties due. The amount of the penalty is equal to 10 percent of the net amount of a taxpayer’s transfer pricing adjustment made by the Canadian tax authorities. Please note that the adjustment does not have to result in tax being due (i.e. A reduction in the amount of loss on a transaction) for the penalties to arise.
The transfer pricing penalty may not apply where a taxpayer made reasonable efforts (i) to determine arm’s length transfer prices or arm’s length allocations in respect of the transaction, and (ii) to use those prices or allocations for the purposes of the Income Tax Act. It is therefore very important for the taxpayer to conduct a pricing studies on a reasonably regular basis so that they can determine current fair market value prices and terms, and to in order to prepare transfer pricing documentation sufficient to substantiate the transfer pricing adopted by the taxpayers.
The only available means to determine arm’s length prices is to use various databases of transactions. These databases and the other sources are not universal, and not always up to date. Even if every effort is made to secure sufficient comparable transactions or overall to secure sufficient comparables with regard to similar entities and their overall or sector/market specific profitability, the development of transfer pricing documentation is as much of an art as it is a science because no two companies or transactions are alike, and adjustments always need to be made for the sake of consistency. The CRA has some very specific and particular views with respect to transfer pricing and what constitutes a comparable. Taxpayers need to engage experienced tax lawyers and economic advisors to deal with these often complicated and detail-oriented discussions with the CRA to achieve a reasonable outcome, both at the audit, reassessment, appeal and competent authority stages.
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