How are prices determined ? Transfer prices are determined by applying the “ arm ’ s-length principle .” This requires that the terms and conditions of relatedparty transactions reflect what independent or arm ’ s-length participants would have agreed to given the same facts and circumstances ( i . e . arm ’ s-length pricing ). This is generally accomplished by treating each related entity within a group as if it were an independent third party whose conduct should reflect external market forces . Practically speaking , this process is more of an art than an exact science .
Why is this important ? A revenue authority has taxing rights on the income generated by a corporation in its jurisdiction . In the absence of arm ’ s-length pricing , the tax liabilities of two companies that belong to the same multinational group but operate in different countries may be distorted . Consequently , if a transaction between related parties is deemed to have been priced differently than it would have been between unrelated parties , tax authorities are able to reallocate income or expenses to reflect the amounts that would have resulted had the transaction been conducted at arm ’ s length . Due to its inherent subjectivity , transfer pricing invites special scrutiny from tax authorities .
But really … so what ? Failing to make reasonable efforts to maintain contemporaneous transfer pricing documentation ( i . e . an explanation of why your intercompany , cross-border prices are arm ’ s length ) can result in a tax authority enforcing adjustments . These adjustments , in turn , may lead to additional tax payable , interest , penalties , double tax ( without an inverse adjustment in the corresponding jurisdiction ), prolonged disputes , loss of reputation , and wasted internal resources .
Further , in today ’ s environment , transfer pricing documentation does not necessarily prevent tax authorities from performing transfer pricing audits and income adjustments . In Canada , the CRA can apply transfer pricing penalties equal to 10 % of the net upward adjustment regardless of whether the taxpayer has turned a profit or even generated revenue . To give you an idea of the rising importance of getting your intercompany pricing right , transfer pricing penalties assessed in Canada alone increased from $ 58.6 million in 2012 to $ 478.5 million in 2015 . 3 Transfer pricing penalties are typically applicable in most jurisdictions , and — in extreme cases — senior officers and signatories may be subject to imprisonment in some countries . Determining arm ’ s-length prices can be a complex and labour-intensive process that involves performing functional , financial , and economic analyses that are beyond the scope of this article . Rather , the purpose here is to explain what it means to align related-party profits with relative value-creation activities and to describe what you can do now to mitigate transfer pricing risks in your business .
3
The Canadian Press ~ OBJ , “ Penalties increasing for Canadian firms shifting profits abroad ,” Ottawa Business Journal , October 7 , 2016 .
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