Navigating trade uncertainty: Tax planning and transfer pricing strategies
Anticipated tariffs on imports from Canada as proposed by President‑Elect Trump have caused significant uncertainty for Canadian businesses involved in cross‑border trade. This bold tariff threat may simply be a negotiating tactic by the U.S. and not materialize. Nevertheless, businesses should expect a challenging and cloudy trade environment where the threat of tariffs is ever present. Moreover, renegotiation of the United States‑Mexico‑Canada Agreement (“USMCA”) will occur during Trump’s presidency.
This renegotiation may not be as beneficial to Canadian interests. The rise in protectionist measures, driven by the “Make America Great Again” (“MAGA”) movement, reflects broader nationalist sentiment under the Trump administration, leading to increased trade friction between the U.S. and Canada. As businesses face potential tariffs or similar trade barriers, many are proactively investigating and adjusting their tax, operational and transfer pricing strategies.
Preemptive business operational change
Companies are already making significant changes to their operations in response to potential new tariffs. Many businesses are assessing their supply chains, sourcing and manufacturing locations to mitigate the risk of this cost increase. For example, companies that were primarily sourcing from China are now shifting production to countries such as Vietnam, or considering manufacturing more of their products within the U.S. These changes are intended to avoid punitive tariffs and ensure continued access to the lucrative U.S. market.
Foxconn, a major supplier for Apple, is leveraging its extensive global manufacturing footprint to shield itself from the effects of U.S. tariffs. By diversifying production across various countries, Foxconn aims to minimize the impact of tariffs on its operations.i Similarly, Best Buy is exploring options to mitigate the impact of potential tariffs on imports from China and Mexico. Despite efforts to diversify suppliers, approximately 60 per cent of Best Buy’s merchandise costs stem from Chinese suppliers, with Mexico and Canada also being significant sources. Best Buy is exploring options such as adjusting shipment timings, altering product assortments and negotiating with vendors to manage the impact of tariffs.ii
Among our clients, we are already noticing the stockpiling of goods sourced from countries subject to tariffs and/or at risk of tariffs.
Long‑term operational changes
Pricing and quantity adjustment
Companies are reviewing the elasticity of their U.S. products, and how much of the cost increase can be shifted to consumers. Planned expansion of non‑U.S. manufacturing could be delayed or cancelled due to the anticipated drops in demand from price increases.
Tax considerations of pricing and quantity changes and the resulting change in profitability are to be reviewed. Market risks must be appropriately allocated to the relevant legal entities. If a U.S. distributor, which operates on a routine and low‑risk basis, experiences a significant drop in profitability due to increased tariffs, it must ensure the position is supportable according to the transfer pricing policy in place. Properly managing risk allocation and demonstrating compliance with arm’s length principles will be essential in avoiding disputes with tax authorities.
Adjusting scope and responsibility of the manufacturer
Another tactic is modifying the functions performed across different jurisdictions. A Canadian company, for instance, that sells most of its manufactured product into the U.S. could consider restructuring to become a toll manufacturer. By changing its structure in this way, the Canadian entity does not take title to the inputs or final product. Instead, the U.S. subsidiary imports the materials, paying tariffs only on those raw inputs rather than the finished goods. The Canadian company would be compensated by a toll manufacturing fee, which could reduce overall tariff costs and optimize cash flow under the new tariff regime.
The shift from traditional manufacturer to toll manufacturer requires modified or new transfer pricing policies. Proper documentation is crucial to support these new roles and ensure compliance with both Canadian and U.S. tax authorities. Companies should also consider the impact on customs duties, permanent establishment risks and withholding tax requirements. Effective planning will require companies to work closely with their tax advisors to optimize their structure for both tax efficiency and tariff mitigation.
Migration of manufacturing activities to the U.S. or lower tariff jurisdictions
Other companies are reevaluating their manufacturing and assembly footprints to align with the evolving trade environment. These companies are considering moving certain manufacturing and assembly activities into the U.S. to mitigate tariff exposure and maintain competitiveness.
Companies must document the rationale for any changes, such as the reduction in tariff exposure, to preempt challenges from tax authorities. Beyond compliance, proper transfer pricing policies can optimize global tax positions, ensuring profits are reported where value is created. Businesses should also address the implications of increased U.S. profitability on the overall group’s effective tax rate, and consider strategies to manage withholding taxes on intercompany dividends, royalties and interest payments.
Establishing a U.S. subsidiary or branch
For many companies currently selling into the U.S. through third‑party distributors or directly, establishing a U.S. subsidiary can provide numerous strategic benefits. Having a U.S.‑based legal entity can provide greater control over operations, reduce costs and potentially lead to significant tax savings. Additionally, positioning as a U.S. entity can enhance a company’s ability to align with the “Buy American” cultural movement, increasing market access and competitiveness in a landscape increasingly favoring domestic suppliers.
These examples illustrate the proactive measures companies can take while considering the complexities introduced by the proposed tariffs. By strategically adjusting their operations, businesses aim to maintain competitiveness and minimize financial disruptions in an evolving trade environment.
Tax considerations for the establishment of a U.S. subsidiary or branch
When expanding into the U.S. from a Canadian company, there are several tax considerations to factor in, particularly if the business is a Canadian Controlled Private Corporation (CCPC):
- Transfer pricing and permanent establishment (“PE”) clarity: If you are uncertain if your U.S. operations qualify as a PE, establishing a U.S. subsidiary provides certainty of having a PE. Through intercompany agreements and transfer pricing documentation, a company can clearly articulate the geographic location of key value adding activities and intellectual property ownership to mitigate overreach risk during an international audit by U.S. or Canadian tax authorities.
- U.S. corporate income tax rates: Understanding and planning for the U.S. corporate tax regime is essential. The U.S. federal tax rate, combined with state‑level taxes, can vary significantly depending on the location of the subsidiary.
- Withholding taxes: Payments such as dividends, interest and royalties between U.S. and Canadian entities will generally be subject to withholding tax. The Canada‑U.S. tax treaty can provide reduced withholding rates, but compliance and planning are necessary to minimize costs.
- Indirect taxes and tariffs: Establishing a U.S. entity can potentially reduce overall tariffs applied to products imported into the U.S. By having a subsidiary import raw materials and conduct manufacturing or assembly in the U.S., businesses may lower tariff costs compared to importing finished goods.
Companies considering establishing a U.S. subsidiary should evaluate these tax implications and the potential benefits of reducing tariffs, gaining better control over operations and improving market access. The current trade environment may make this an opportune time to expedite plans for expansion.
Other transfer pricing strategies
Increasing U.S. profitability within the arm’s length range
One strategic approach to mitigate the impact of tariffs is to adjust transfer pricing policy to materially increase profit reported in the U.S., or by a U.S. subsidiary of a non‑U.S. parent company. This increased profitability can be achieved by reducing the price of the imported product, thereby lowering the tariff assigned to the product. By pricing imported goods at a lower value, tariff cost is reduced, which can lead to higher profit margins within the U.S. entity.
Transfer pricing policies often have ranges of profitability that are supportable to both tax jurisdictions. Within this range of profitability, the pricing can be adjusted so the U.S. entity is positioned at the top of the accepted and supportable profit range. This approach is particularly relevant for transfer pricing policies using a profit‑based method as the most appropriate method. By positioning the U.S. entity at the higher end of the profit range, companies can maximize profitability in the U.S., while still adhering to arm’s length principles and maintaining compliance with applicable tax regulations.
This is a relatively simple and conservative strategy, and analysis performed on a few of our clients observed a noticeable financial benefit. However, the unbundling play described next tends to have a larger financial benefit.
Unbundling
Companies can unbundle intellectual property (“IP”) components, business support services and potentially operational services such as procurement and quality assurance that have been bundled in the transfer price for ease of implementation objectives. By separately pricing these elements, the product’s base price can be reduced, thereby minimizing the tariff burden. Unbundling IP royalties or service fees can also help optimize the profitability of different entities within the corporate group, ensuring income is allocated in a tax‑efficient manner across jurisdictions.
These strategies require careful consideration and thorough documentation to ensure compliance with transfer pricing regulations in both the U.S. and home country of the parent company. Companies must demonstrate the adjusted pricing reflects arm’s length terms and that the allocation of income is justified based on the functions, assets and risks assumed by each entity. Proper implementation of these strategies can help companies effectively manage tariff costs while optimizing their overall tax position.
Impact on valuation and M&A activity
The impact of tariffs also extends to company valuations, both in Canada and the U.S. Canadian companies exporting to the U.S. may see reduced valuations due to lower profit margins resulting from tariffs, while U.S. companies could face increased costs and potential retaliatory tariffs. These changing values may directly affect the number of mergers and acquisitions (M&A) expected over the next few years, as the Trump administration’s cross‑border policies create additional uncertainty.
M&A activity may decrease, or the structure of deals may fundamentally change as companies struggle to accurately assess the risks and opportunities of cross‑border expansions in this environment. However, this impact could also create opportunities for U.S. investment in Canadian companies with lower valuations due to the economic impact of these tariffs. Tax planning with acquisitions and mergers will need to conduct a sensitivity analysis with unexpected valuation shifts.
Supply chain overcapacity déjà vu
As tariffs loom, companies are considering inventory strategies such as stockpiling goods within the U.S. This increase in inventory, however, brings added supply chain costs, including storage and logistics expenses. Companies must also consider the lessons learned during the COVID‑19 pandemic, where disrupted supply chains led to inefficiencies and higher costs. Proper planning and effective supply chain management are vital to ensure companies do not repeat these issues while mitigating risks associated with increased tariffs.
Next steps
Our specialty tax team has deep expertise in navigating cross‑border tax challenges, transfer pricing, M&A, inbound and outbound taxation, due diligence reviews and international corporate restructuring optimization. We understand the complexities businesses face in light of these proposed tariffs and can provide tailored guidance to optimize your operations, minimize risk and ensure compliance.
Contact your Baker Tilly advisor today to learn more about how we can support your business in this challenging landscape.
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