If you own or operate a small‑ to medium‑sized enterprise (SME) with business operations in two or more countries, congratulations! You have a multinational enterprise (MNE).
As a MNE, you may be impacted by transfer pricing. Specifically, if you and another entity within your MNE buy or sell goods or services, use the same brand and trademarks, access or grow the enterprise’s intellectual property and have intercompany funding with each other, these transactions must be priced properly to ensure the appropriate profit is reported in Canada.
The arm’s length principle
Transfer pricing legislation stipulates transactions between entities of a MNE must occur under “arm’s length” terms and conditions. For tax purposes, the arm’s length principle means the terms and conditions should be identical whether you are dealing with parties at arm’s length or not.
Are transfer pricing requirements for SMEs the same as the requirements for the biggest global companies? Thankfully, no. That’s because Canada is a member and contributing participant of the Organisation for Economic Co‑operation and Development (OECD), which maintains and updates global guidance for transfer pricing. Paragraph 3.83 of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2022 edition) recognizes different enterprises should have requirements that match their risk:
“Although the arm’s length principle applies equally to small and medium‑sized enterprises and transactions, pragmatic solutions may be appropriate in order to make it possible to find a reasonable response to each transfer pricing case.”
This means there is a diminished expectation of SMEs for their transfer pricing support, but the support must be reasonable, and reasonableness varies case‑by‑case.
The basics of transfer pricing requirements
The first and primary requirement for all MNEs is to follow the arm’s length principle. MNEs must demonstrate their cross‑border related‑party transactions follow prices, terms and conditions they would have had with a non‑related party. MNEs must convince four different groups the arm’s length principle is being followed.
Tax authorities
If the tax authorities believe your related party transactions do not follow the arm’s length principle, your organization may be assessed additional tax, penalties and interest, leading to a potential double taxation problem.
Accountants
Your accountants will need to know about your transfer pricing policies to help you manage risk and complete annual foreign reporting forms accurately. If your financial statements are audited, your accountants must be assured your transfer pricing policies and procedures follow arm’s length terms and conditions, and they will request a written document supporting your policies.
Financial statement auditors
Financial statement auditors may want to determine how supportable your transfer pricing documentation will be to tax authorities in the event of reassessment, how large any reassessment may be and what your maintenance practices are to keep your transfer pricing policies and documentation up‑to‑date.
Owners and shareholders
Both existing and potential future owners of the business have a keen interest in the strength and basis of your transfer pricing policies. Owners want to be assured the company has sound transfer pricing governance and procedures and transfer pricing risks are managed due to the potential tax and penalties involved. Public knowledge of any transfer pricing disputes could also negatively impact the company’s brand value.
Transfer pricing supporting documentation
The importance of transfer pricing support varies by MNE. A startup MNE is subject to different expectations than an established, large and financially secure MNE in a mature industry.
How can small‑ and medium‑sized MNEs support their transfer pricing policy on a limited compliance budget? How can they apply pragmatic approaches while being assured their transfer pricing policies and supporting files are sound?
The pyramid below outlines the layers of available support Baker Tilly can provide to clients.
The pyramid’s base represents the lowest support level. A memo describing your transfer pricing policy is valued by your company’s accounting team, but it does not adequately demonstrate if your policy follows the arm’s length principle. A larger MNE would need a formal transfer pricing letter providing support as to why a certain transfer pricing policy is followed – this is also required by financial statement auditors. As transaction size increases and your MNE grows, a formal transfer pricing report following Canadian legislation will mitigate documentation‑related penalties.
The top of the pyramid represents annual documentation prepared for each relevant jurisdiction, plus a combination of advanced pricing agreements negotiated between the MNE and one or more tax authorities. This practice is typical for large MNEs but cost prohibitive for smaller ones.
The bottom line: your transfer pricing requirements increase as your MNE grows. Baker Tilly’s experts can help you determine the best level of support for your company.
Empirical data support pyramid
A transfer pricing policy may have certain profit level targets or profitability ranges incorporated into the calculation for the cross‑border transaction. These fixed‑value inputs are supported through economic analysis, benchmarks or surveys. The empirical support pyramid has three tiers, with the highest level providing the strongest support.
Small MNEs may not have the same requirements to support certain profit targets as larger MNEs with higher risk of transfer pricing reassessment. The consequences of a reassessment may be more severe for others. As your MNE grows, stronger empirical support is advised and will eventually be a requirement for your financial statement auditors and tax authorities who will review and analyze your transfer pricing policies.
Legal framework pyramid
Certain industries and transaction types have a higher risk of recharacterization. This is the risk that a tax authority may disagree with the form and substance of your transaction, not just the price and terms.
For example, consider a Canadian subsidiary providing contract research and development that enhances a top‑selling product, service or software platform. This subsidiary may charge other entities in the group for use of its intellectual property based on cost plus a fixed percentage of markup. The Canada Revenue Agency may decide the scope and responsibility of the Canadian operations are greater, and the Canadian entity is the economic owner of the intellectual property. The cost‑plus payment could be recharacterized as a royalty of worldwide sales, leading to reassessment of tax and penalties.
A formal intercompany legal agreement consistent with your transfer pricing documentation will add resiliency to any recharacterization reassessment exposures.
Prior to a formal intercompany legal agreement, your MNE may decide to map out the nature of the agreement while global revenues are relatively small. A term sheet or description of key terms of the foreseen intercompany legal agreement may serve as a short‑term measure to lower recharacterization risks.
Relationship of revenue and transaction size to transfer pricing requirements
In Canada, there are different transfer pricing requirements for Canadian legal entities that are part of a MNE. Revenue size is the top factor determining your company’s requirements. Documentation penalty thresholds decrease for Canadian entities when revenues are less than $5 million. If the Canadian entity of a MNE is part of a global consolidated group with annual revenues exceeding 750 million EUR, additional annual country‑by‑country reporting requirements apply.
The other key factor determining your business’s transfer pricing requirements is the size of the related party transactions. All Canadian companies must file a T106 information return when the sum of all transactions with a particular non‑resident during the year exceeds $100,000 CDN.
Experience you can rely on
At Baker Tilly, our experts have a comprehensive range of experience in transfer pricing compliance, restructuring, tax planning, assessing existing transfer pricing policies and procedures and defending transfer pricing positions and policies to various tax authorities. Working closely with you, we determine the most appropriate strategy and customize it to fit the needs of your MNE.
Contact your Baker Tilly advisor today to get started on a transfer pricing plan that minimizes your MNE’s risk.
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