Entrepreneurs like to think big. It’s in their nature. For some, that means setting up related companies in the U.S. and abroad to grow their business. But in doing so, many entrepreneurs unwittingly expose themselves to tax-time bombs that can explode unexpectedly unless they defuse them by taking action ahead of time.
You may think of your group of companies as members of a tight-knit family, but once you cross international borders, it’s a new ball game. For example, “transfer pricing” laws require that your group of companies operate at arm’s length when doing business with each other. All transactions must be based on the fair market value of all property, goods and services. If not, you could potentially face surprise tax assessments and penalties that could deal a serious blow to your company’s financial well-being.
These transfer pricing laws are designed to ensure that each jurisdiction gets its fair share of the tax pie. Essentially, they’re intended to prevent a corporate group from moving its income from one jurisdiction to another by having a company in one jurisdiction pay prices for goods or services to a related company in another jurisdiction that are higher than a company dealing at arm’s length would be willing to pay. From the taxpayer’s point of view, there’s often a bias towards shifting income to a lower tax jurisdiction.
While the Canada Revenue Agency (CRA) will routinely scrutinize large multinational corporations, the agency will also do transfer pricing audits on small to medium-sized businesses, including those with less than $10 million in revenue. In fact, if your Canadian company has transactions with related non-resident companies that total at least $1 million per year, you have to file an annual form disclosing these transactions.
Even if your inter-company transactions are less than $1 million per year, you still need to establish that you’re using arm’s length prices. This principle applies not only to goods but to services as well, including management fees, loan guarantee fees, interest charges on loans, licensing fees and royalties.
The CRA accepts several methods for calculating transfer prices. To meet the necessary documentation requirements, you need to choose the method that best suits your business and be prepared to defend your choices. You also need to create a paper trail concurrently with each transaction that accurately describes the participants, their relationship to each other, the nature of the goods and services involved, along with any applicable terms and conditions.
The CRA can go back as far as seven years to re-evaluate transfer prices involving non-arm’s length transactions with non-residents. If the CRA should disagree with your pricing approach, your company could be hit with a major tax increase plus interest for late payment. We have seen governments deny a deduction in one jurisdiction for income that was taxed in another jurisdiction, effectively taxing that income twice.
To help defuse this potential tax-time bomb in your companies, make certain your transfer pricing documents are up to date, clear and concise. It is never a good idea to wait until the CRA comes knocking to try to reconstruct the details of events that have long since passed. Put the paper in place to reflect the “here and now” so you’ll be able to properly defend your transfer prices if you’re challenged by the CRA or foreign tax authorities.